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Dynamic portfolio and mortgage choice for homeowners

Hemert, Otto van, Jong, Franck de and Driessen, Joost (2005) Dynamic portfolio and mortgage choice for homeowners. Discussion paper: UBS Pensions Series 036, 538. Financial Markets Group, London School of Economics and Political Science, London, UK.

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Abstract

We investigate the impact of owner-occupied housing on financial portfolio and mortgage choice under stochastic inflation and real interest rates. To this end we develop a dynamic framework in which investors can invest in stocks and bonds with different maturities. We use a continuous-time model with CRRA preferences and calibrate the model parameters using data on inflation rates and equity, bond, and house prices. For the case of no short-sale constraints, we derive an implicit solution and identify the main channels through which the housing to total wealth ratio and the horizon affect financial portfolio choice. This solution is used to interpret numerical results that we provide when the investor has short-sale constraints. We also use our framework to investigate optimal mortgage size and type. A moderately risk-averse investor prefers an adjustable-rate mortgage (ARM), while a more risk-averse investor prefers a fixedrate mortgage (FRM). A combination of an ARM and an FRM further improves welfare. Choosing a suboptimal mortgage leads to utility losses up to 6%.

Item Type: Monograph (Discussion Paper)
Official URL: http://fmg.lse.ac.uk
Additional Information: © 2005 The Authors
Library of Congress subject classification: H Social Sciences > HG Finance
H Social Sciences > HB Economic Theory
Sets: Research centres and groups > Financial Markets Group (FMG)
Collections > Economists Online
Collections > LSE Financial Markets Group (FMG) Working Papers
Rights: http://www.lse.ac.uk/library/usingTheLibrary/academicSupport/OA/depositYourResearch.aspx
Identification Number: 538
Date Deposited: 29 Jul 2009 12:02
URL: http://eprints.lse.ac.uk/24650/

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