Can the Wealth-to-Income Ratio be a Useful Predictor in Alternative Finance? Evidence from the Housing Risk Premium

Abstract

Purpose – The purpose of this chapter is to assess the role of the wealth-to-income ratio in forecasting housing risk premium. Methodology/approach – To investigate this issue, the chapter uses the residuals of the trend relationship among asset wealth and labor income to predict future real housing returns. It shows that deviations of asset wealth from its cointegrating relationship with labor income, wy, track time-variation in expected housing returns. Findings – Using data for a set of industrialized countries, this chapter finds that if agents are hit by a shock that generates a fall in the wealth-to-income ratio, they will demand (i) a higher housing risk premium when housing assets are complements of financial assets and (ii) a lower housing risk premium when housing assets are substitutes of financial assets. Originality/value of chapter – The findings of this chapter are novel in the field of alternative finance and, in particular, durable (housing) finance. Indeed, they build on a representative agent's theoretical model to infer about the degree of substitution or complementarity between financial and housing assets, which, in turn, can be useful at developing investment strategies for hedging against the risk of unfavorable housing fluctuations. Additionally, they open a new research avenue for understanding the determinants of housing risk premium by linking the dynamics of asset wealth and labor income with the behavior of future housing returns.