Abstract
The present value model of asset prices a la Campbell and Shiller predicts the price-rent ratio in the housing market to be stationary. The observed movements in the actual price-rent ratio, often exhibiting large and long swings in the ratio, may put into question the validity of the standard present value model. In this paper, we allow for two sources of possibly unwieldy deviations in the price-rent ratio in the standard present value model, and examine the relative importance of the standard model and the two extra features using the Italian house market data. The results strongly support the validity of the standard present value model, in which the up- and down-swings in the price-rent ratio are mostly explained by the movement in the expected risk premium, whereas the bubble and regime-switching expectation does not make sizable contributions to the price-rent ratio. Our results suggest that the standard present value model is a reliable vehicle in explaining the price-rent ratio.
Highlights
The present value model proposed by Campbell and Shiller [1] [2] has gained popularity and been frequently used in asset pricing literature
The boom-bust behavior of the Italian price-rent ratio is mostly explained by the movement in the expected risk premium, whereas the bubble and regime-switching expectation does not make any sizable contributions to the price-rent ratio
Our results suggest that the standard present value model is a reliable vehicle in explaining the price-rent ratio, even if it exhibits long swings, as long as it is mean-reverting within a reasonable period of time
Summary
The present value model proposed by Campbell and Shiller [1] [2] has gained popularity and been frequently used in asset pricing literature. To the extent that future rents are the intrinsic income flow and expected to move more or less hand with house price, large and long swings in their ratio may put into question the applicability of the present value model in the first place. Such large and sustained deviations in the price-rent ratio from the historical average motivate us to examine whether the present value model in its standard form can still be used for empirical studies. Our results suggest that the standard present value model is a reliable vehicle in explaining the price-rent ratio, even if it exhibits long swings, as long as it is mean-reverting within a reasonable period of time
Sign-in/Register to view highlights & summary Sign-in/Register to access full text options 
Talk to us
Join us for a 30 min session where you can share your feedback and ask us any queries you have
Schedule a callDisclaimer: All third-party content on this website/platform is and will remain the property of their respective owners and is provided on "as is" basis without any warranties, express or implied. Use of third-party content does not indicate any affiliation, sponsorship with or endorsement by them. Any references to third-party content is to identify the corresponding services and shall be considered fair use under The CopyrightLaw.
