An Intertemporal Capital Asset Pricing Model With Owner Occupied Housing

This paper studies the portfolio choice and asset pricing in the presence of owner-occupied housing in a continuous time framework. Owner-occupied housing serves as an important consumption good as well as a dominant asset for most households. The theory part of this paper shows that the market portfolio is not mean-variance efficient; and traditional CAPM fails in a model with owner-occupied housing; however, a conditional linear factor pricing model can still be derived, in which the market portfolio return and housing return are two pricing factors. Moreover, the nondurable consumption to housing ratio, ch, is shown to affect expected returns in the same way as cay (the consumption-to-wealth ratio in Lettau and Ludvigson 2001a, 2001b) The empirical evidence shows that ch can predict asset returns at various horizon ranging from one quarter to two years. ch is also shown to enter linearly the stochastic discount factor of the economy. The cross-sectional Fama-MacBeth regressions show that the conditional models conditioning on ch perform much better than their unconditional counterparts, and the conditional two factor model derived in this paper performs almost as good as Fama-French three-factor model