Hedging house price risk in the presence of lumpy transaction costs

This paper presents a life-cycle model of housing demand with uncertain house prices and lumpy transaction costs. The paper extends the (S, s) methodology to a non-stationary discrete time framework with multivariate stochastic price processes. This allows the characterization of a self-hedging mechanism in an incomplete housing market: households use earlier accumulated housing wealth to hedge against future housing cost risk. As a result, the direction of the effect of price uncertainty on housing demand depends critically on households' future housing consumption plans. When price uncertainty increases, households consume (and thereby invest in) less housing if they plan to realize the housing wealth gain. However, they will instead take a larger housing position if they plan to move to a bigger home in a correlated housing market in the future. (C) 2008 Elsevier Inc. All rights reserved.