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Efficient Portfolios When Housing is a Hedge Against Rent Risk

In this paper we address the issue of the efficiency of household portfolios in the presence of housing risk. We present a theoretical model in which housing needs are age-dependent but exogenously determined, and consumers choose whether to rent or own the corresponding housing stock. Consumers also decide their consumption of a non-durable good and their financial investment strategies. They can invest in a risk-less asset (that includes human capital) and n risky financial assets. If the rental value of housing has a positive correlation with house prices, owning is a hedge against rent risk. When this correlation is unitary, we show that efficient financial portfolios should be the sum of a standard Markowitz portfolio and of a hedge term. This hedge term is a function of the correlations between housing and financial assets returns and multiplies the difference between the value of the housing stock owned and the present value of current and future housing needs. In our application we use Italian household portfolio data and time series data on financial assets and housing stock returns. Our empirical results support the view that the presence of housing risk plays a key role in determining whether household portfolios are efficient. They also highlight the need to distinguish between households who are long on housing (homeowners whose housing needs are declining) or short on housing (tenants and homeowners whose housing needs are still increasing).