The Effect of Financial Market Factors on House Prices: An Expected Utility Three-Asset Approach

Abstract

This study aimed to theoretically identify the impact factors of the financial market on house prices. Developed upon the two-asset model and with the consideration of risky financial assets, our three-asset model reveals a new derivation of house prices. Compared with the two-asset model, the newly emerged term is similar to the Sharpe β; therefore, it is a risk premium term. Based on China’s 2001–2018 panel data, theoretical derivations are examined. However, the short-term effect of this risk term on house prices is practically small. Given the nonlinear pattern, the long-term effect of the risk term is checked by repeated stochastic simulation. The results imply the following: (i) real house prices are nonlinearly affected by three financial market factors, namely, the expected financial market return, financial market volatility, and the correlation between housing and financial markets; (ii) the correlation determines the signs and the significance of the effects of the other two factors; and (iii) the naturally changed correlation causes periodic house price fluctuations. Therefore, to stabilize real house prices, it is recommended that the government control the money flow between the two markets.