IRES2010-014

IRES Working Paper Series

The Relationships between Real Estate

Price and Expected Financial Asset
Risk and Return:
Theory and Empirical Evidence
Gang-Zhi FAN
Zsuzsa R. HUSZR
Weina ZHANG

October, 2010

The Relationships between Real Estate Price and Expected

Financial Asset Risk and Return: Theory and Empirical Evidence
Gang-Zhi FAN* Zsuzsa R. HUSZR, Weina ZHANG
October 2010
Abstract
In pricing real estate with indifference pricing approach, market incompleteness significantly
distorts the conventional pricing relationships between real estate and financial asset. In this
paper, we focus on the pricing implication of market comovement because comovement tends to
be stronger in financial crisis when investors are especially sensitive to price declines. We find
that real estate price increases with expected financial asset return but only in weak market
comovement (i.e., a normal market environment) when investors enjoy diversification benefit.
When market comovement is strong, real estate price strictly declines with expected financial
asset return. More importantly, contrary to the conventional positive relationship, real estate
price generally declines with expected financial asset risk. Even when market comovement is
strong, real estate price only increases with financial asset risk when the risk is low but
eventually declines with the risk when it becomes high. These nonlinear price relationships
highlight the importance of asset market comovement that is usually overlooked by conventional
option pricing model developed in complete market setting.
Keywords: Comovement, indifference pricing, incomplete market, real estate, risk and return
JEL: G1, G12

Southwestern University of Finance and Economics, Research Institute of Economics and Management, Chendu,
Sichuan Province, China, phone: +86-28-87099192, fax: +86-28-87099300, email: gzfan@swufe.edu.cn.
National University of Singapore, NUS Business School, Department of Finance, 15 Kent Ridge Drive, Singapore
119245, phone: +65-65168017, email: bizhzr@nus.edu.sg. Huszr is also affiliated with the Institute of Real
Estate Studies (IRES) and the Risk Management Institute (RMI) at the National University of Singapore.
Corresponding author. Zhang is from National University of Singapore, NUS Business School, Department of
Finance, 15 Kent Ridge Drive, Singapore 119245, phone: +65-65168120, fax: +65-67792083, email:
weina@nus.edu.sg. Zhang is also affiliated with the Institute of Real Estate Studies (IRES) and the Risk
Management Institute (RMI) at the National University of Singapore.
We thank Yakov Amihud, Yongheng Deng, Philip H. Dybvig, Allaudeen Hameed, Ravi Jagannathan, Andrew
Karolyi, Jun Liu, Deborah Lucas, Takeshi Yamada, Martin Spencer, Suresh Sundaresan, Tien Foo Sing, Tianshu
Chu, Shihe Fu, and seminar participants at Southwestern University of Finance and Economics for their helpful
discussions and comments. We also thank our discussants Wenlan Qian and Sau Kim Lum and the participants at
the 2010 Asian Finance Association Meeting and at the 2010 Asian Pacific Real Estate Research Symposium in
Hong Kong. Any errors are our own.

The Relationships between Real Estate Price and Expected

Financial Asset Risk and Return: Theory and Empirical Evidence

Abstract
In pricing real estate with indifference pricing approach, market incompleteness significantly
distorts the conventional pricing relationships between real estate and financial asset. In this
paper, we focus on the pricing implication of market comovement because comovement tends to
be stronger in financial crisis when investors are especially sensitive to price declines. We find
that real estate price increases with expected financial asset return but only in weak market
comovement (i.e., a normal market environment) when investors enjoy diversification benefit.
When market comovement is strong, real estate price strictly declines with expected financial
asset return. More importantly, contrary to the conventional positive relationship, real estate
price generally declines with expected financial asset risk. Even when market comovement is
strong, real estate price only increases with financial asset risk when the risk is low but
eventually declines with the risk when it becomes high. These nonlinear price relationships
highlight the importance of asset market comovement that is usually overlooked by conventional
option pricing model developed in complete market setting.

Keywords: Comovement, indifference pricing, incomplete market, real estate, risk and return
JEL: G1, G12

I. Introduction
Conventional financial asset pricing models may not be applicable to real estate because real
estate is different from financial assets in terms of transaction costs, investment options, and
nondiversifiable idiosyncratic risk.1 In addition, investors often have different risk preferences
that can result in non-trading or infrequent trading. Taken all together, in the presence of these
market imperfections, conventional option pricing (Black and Scholes, 1973; Merton, 1973) and
real option pricing models (e.g., Titman, 1985; McDonald and Siegel, 1986) may not be readily
applicable to real estate. Recently, Henderson (2007) and Miao and Wang (2007) account for
market incompleteness in real option framework and find that investor risk aversion and
nondiversifiable idiosyncratic risk significantly reduce real asset price. However, these studies
do not explicitly examine how market incompleteness influences the price relationship between
real asset and financial asset. Our paper fills in this void in the literature.
We adapt the indifference pricing approach (IPA) proposed by Hodges and Neuberger (1989)
because it is intuitive and can provide a realistic representation of the real estate market. In IPA
the real estate transaction takes place if the buyers highest offer price equals or exceeds the
sellers lowest ask price. At the minimum ask price, the seller is indifferent between selling the
real estate and investing the proceeds or keeping the real estate because his expected utility is the
same from the two alternatives. Similarly, at the maximum offer price, the buyer is indifferent
between buying the property or keeping the money and investing it in financial assets (Musiela
and Zariphopoulou, 2004; Elliott and van der Hoek, 2009). In complete market, the results from
the IPA resemble those from the standard real option pricing approachreal estate price
decreases with expected financial asset return and increases with expected financial asset risk.
However, the IPA approach provides significantly different price-return and price-risk
relationships once we assume away market completeness. Specifically, we focus on the market
incompleteness caused by heterogeneous risk aversions, nondiversifiable idiosyncratic risk and
the inability to replicate the real estate payoffs by a combination of the riskless and risky
financial assets payoffs. For simplicity, in the text we refer to the latter aspect as
nonsynchronous market comovement. Not only we show that risk aversions and idiosyncratic
1

For example, Garmaise and Moskowitz (2004) emphasize that real estate is unique asset class because of the high
transaction cost and illiquidity while Quigg (1993), Capozza and Li (2001, 2002) and Ambrose (2005) stress the
difficulty of hedging real estate with financial asset in the presence of significant nondiversifiable idiosyncratic
risk.

risk reduce real estate price ceteris paribus, we also find that with realistic model parameters risk
aversions and idiosyncratic risk do not distort the linear relationship between real estate price and
financial asset returns and risk as much as the market comovement does.
Our analysis specifically focuses on the pricing implication of market comovement in
conjunction with changing financial asset return and risk because there is a growing concern to
understand the role of market comovement in portfolio diversification (e.g., Buraschi, Porchia
and Trojani, 2010). Investors realized that even the traditionally well-diversified portfolios
experienced significant losses as market comovement strengthened in the recent crisis. While
numerous studies mention that international equity market comovement is time-varying (e.g.,
Longin and Solnik, 1995; and Ledoit, Santa-Clara, and Wolf, 2003; et al), there are only a few
studies that examine the time-varying comovement between real estate and equity market (e.g.,
Ibboston and Siegel, 1984). To our knowledge, no prior studies have examined the impact of
market comovement on price-return and price-risk relationships between real estate and financial
market. Our theoretical results show that real estate price is less negatively correlated with
financial asset return when market comovement is weak (i.e., a normal market environment in
the United States) as investors can enjoy diversification benefits. However, when market
comovement is strong, real estate price strictly declines with expected financial asset return.
Moreover, the relationship between real estate price and expected financial asset risk is nonmonotonic and even nonlinear. Contrary to the results from conventional standard real option
approach, in incomplete market real estate price strictly decreases with expected financial asset
risk in weak market comovement. In strong market comovement (e.g., crisis), a small increase in
financial asset risk results in higher real estate price initially, but eventually the price declines
with the risk. This nonlinear relationship, which is entirely overlooked in the standard option
setting, may help investors to better understand the challenges of real estate investment in
changing market environment or across different countries with different degree of market
comovement.
Lastly, we empirically examine the real estate data from five countries, including Hong Kong,
New Zealand, Singapore, the United Kingdom, and the United States to test our model
implications. Our sample captures a wide range of market conditions that are particularly suitable
for testing our model predictions. On average the United Kingdom and the United States real
estate markets have relatively weak market comovement compared to the smaller economies
3

such as Singapore and Hong Kong. 2 In addition, all countries exhibit some degree of timevarying market comovement. We show that both the negative relationship between real estate
price and expected financial asset return and the positive relationship between the price and
expected financial asset risk are distorted by market comovement. Overall, our findings suggest
that investors need to pay attention to market comovement when pricing real estate because the
pricing relationships known from traditional pricing models (in real option framework) can be
significantly different in the real world.

II. Indifference Pricing of Real Estate

In this section, first we introduce the indifference pricing approach (IPA) and its applicability to
price real estate in an incomplete market. 3 Then, we derive the bid and ask prices for the buyer
and the seller under IPA and verify that the results are consistent with those from standard option
pricing theory in complete market. Lastly, we present the pricing of real estate in incomplete
market setting in the presence of heterogeneous risk aversions (of investors), nondiversifiable
idiosyncratic risk and nonsynchronous comovement of real estate and financial markets (or
equivalently, the imperfect payoff correlation of real estate and financial asset in our setting).

Introduction to IPA
Although IPA has been introduced decades ago (Hodges and Neuberger, 1989), its benefits in
terms of strong intuition and general applicability have only recently been recognized in
academic studies. In IPA, transaction takes place when the buyer's bid price is higher or equal to
the seller's ask price. It is important to note that in complete market, IPA resembles the standard
real option pricing approach and implies that real estate price decreases with the expected
financial asset return and increases with the expected financial asset risk. In our analysis, the
main advantage of IPA is that it is easily adjustable to incomplete setting and allows us have a

These results are consistent with Quan and Titman (1999) and Bond, Karolyi, and Sanders (2003) who show that
real estate markets in the Asia-Pacific region are more co-integrated with the financial market and these real estate
markets are also more sensitive to country-specific market risk than those in Europe or North America. Another
recent paper by Fei, Ding, and Deng (2008) find that the conditional correlation among REITs, stock and direct
real estate returns are time varying. Moreover, they also show that the higher correlation between equity REIT and
direct real estate is related to higher future returns of equity REIT.
Hereafter, for simplicity we use the term financial asset return to represent the expected payoff from the risky
financial asset and the term financial asset in referring to the risky financial asset.

examination of changes in real estate price in response to the changes in expected financial asset
return and risk as we choose a realistic model setting for the real estate market.

Model Setup
Following Titman (1985) and Miao and Wang (2007), we select vacant urban land as a
representative real estate because it is known to contain significant nondiversifiable idiosyncratic
risk and an investment option.4 In adopting IPA, we closely follow Musiela and Zariphopoulou
(2004) and Elliott and van der Hoek (2009) and establish a two-agent, two-period economy,
where the agents (i.e., buyer and seller) at time 0 decide whether to invest in the vacant land and
receive the payoff from the developed land (with a constructed property) at time T. Since agents
are making decisions based on utility maximization, in our simple economy the sale/purchase
option at time 0 provides Pareto improvement for both agents.
Agent A, the current owner of the vacant urban land with an area of k square feet, at time 0,
~
can construct a property of q() units on the land by time T and sell each unit for YT , where q() is
~
increasing in k. The realization of the unit price YT at time T can be either YTu in good state or

YTd in bad state with real probabilities pYu and pYd respectively. The unit construction cost is
denoted as C(), which is an increasing and convex function of the number of units q(k).
Alternatively, agent A can sell the land in an open auction at time 0 and invest the proceeds in
two types of traded financial assets: a riskless asset with a gross return of R by time T, and a
risky asset priced at S0 at time 0 with payoff ST at time T. ST is either STu in the good state with
probability pSu or STd in the bad state with probability pSd . His reservation value of the land gives
him at least the same utility in a utility maximization framework as the choice of keeping the
land and developing a property on it by time T. 5

IPA is flexible, and can be easily adopted to developed land or existing real estate as its underlying principle is
utility maximization of the different agents (e.g., buyer and seller) expected wealth instead of non-arbitrage
argument in complete markets.
A large body of literature has developed binomial or trinomial models to price various contingent claims (e.g.,
Cox, Ross and Rubinstein, 1979; Boyle, 1988; Buttimer et al., 1997). In these models, asset prices are obtained via
binomial or trinomial models. For example, Cox, Ross and Rubinstein (1979) show that the stochastic process of
underlying asset in the Black-Scholes model is only a special case of their binomial model. Therefore, they show
that the binomial model can be a good approximation of real world circumstances. Similar to Cox, Ross and
Rubinstein (1979), we allow for a binomial tree model in the setting.

There exists one potential buyer, agent B, who would bid for the land in the auction if she
obtains the same or higher utility from the purchase than investing all her wealth in the traded
financial assets. If agent Bs bid price is higher than agent As reservation price, agent B gains
ownership and will decide about the optimal units to construct on the land according to her utility
function. As in Henderson (2007), to derive a closed-form solution from our model we use
exponential utility for our agents with the following form,
U (w) = e w , where w > 0 and > 0 ,

(1)

where is an investors coefficient of risk aversion and w is the investors wealth. 6 For
simplicity, we assume that both agents have complete information about the real probabilities of
all future events. We apply the IPA to this simple economy to solve for land price for both agents.
Definition 1: The indifference price to agent A (the owner) is defined as the amount which gives
him the maximum expected utility and thereby making him indifferent between developing the
land ( VaL ) and selling the land ( V aT ). Thus, Pa, the unit price of the real estate that satisfies
VaL ( wa ,k ) = VaT ( wa + kPa )

(2)

for all initial wealth levels ( wa ) and k square feet. VaL is the agent As maximal expected utility
when he invests in the real estate and VaT is his maximal expected utility from other alternative
investment opportunities (e.g.,

investing in risky financial assets) without the real estate.

Similarly, agent B's (the bidder) unit indifference price, Pb, is the amount that satisfies
VbT ( wb ) = VbL ( wb kPb , k )

(3)

for all her initial wealth levels wb . VbT is her maximal expected utility obtained from alternative
investment rather than investing in the real estate, and VbL is her maximal expected utility with
the real estate.
This Definition 1 can be regarded as a partial equilibrium concept whereas any agent in the
economy will be indifferent between the available investment opportunities.
Seller (Agent A) Utility Maximization in IPA
6

The choice of exponential utlity function is due on the availability of the closed-form solutions under IPA. As the
exponential utility function is one of the mostly widely used utility functions in asset pricing literature, we believe
that our results can be generally applicable.

If agent A keeps the land, he maximizes his utility by choosing the optimal construction size
q(k )* on his k square feet of the vacant land at time 0 satisfying
q(k )* = arg max ( q( k )Y0 C ( q( k )) ) ,
q (k )

and receives the payoff from the constructed project on the land q* (k )YT C (q* (k )) by time T,
where YT is the payoff of the constructed property at time T and C() is the construction cost.
Assuming agent A has an initial wealth of wa , he can invest in X units of riskless financial asset
with a one-period gross return of R and units of the risky financial asset with the initial price
of S0 , which results in payoff of XR + ST at time T. 7 Substituting X out by wa, the payoff at
time T from the investment is wa R + ( ST RS0 ) . The optimal utility VaL from the land sale is
expressed in the following equation,
VaL (wa , k ) = max E P ( S~

~
,YT )

{ exp[ (w R + (S~
a

)]}

~
RS 0 ) + q ( k ) * YT C ( q ( k ) * ) ,

subject to q(k )* = arg max ( q( k )Y0 C ( q( k )) ) .

(4)
(5)

q (k )

E P ( S~ ,Y~ ) in the above equation is the expectation operator with real probabilities pSu , pSd , pYu ,
T T
pYd , and a is the risk aversion coefficient of agent A. Alternatively, if he decides to sell for a

price of kPa , he can invest all his wealth wa+kPa at time 0 in X units of the riskless financial
asset and units of the risky financial asset. By substituting X out, his wealth at time T is
~
( wa + kPa ) R + ( ST S 0 R) and his maximal expected utility VaT can be expressed as,

)}

~
V aT (wa + kPa ) = max E P( S~T ) exp a (( wa + kPa )R + ( S T RS 0 )) ,

(6)

where EP( S ) in equation (6) is the expectation operator with real probabilities psu and psd .
T
Intuitively, agent A is indifferent between selling the land or keeping it when his utilities based
on expectations from the sale and non-sale are the same, i.e., VaL = VaT .

In this setting, we assume that there is infinite supply of riskless and risky financial assets. While Heaton and
Lucas (1996) discuss how market incompleteness may be the result of finite supply of financial assets, we do not
pursue that type of market incompleteness in this paper, but focus on heterogenous risk aversions,
nondiversifiable idiosyncratic risk, and nonsynchronous market comovement.

Buyer (Agent B) Utility Maximization in IPA

Similarly, agent B can chose to purchase the land or she can invest all her wealth wb into riskless
financial asset and risky financial asset. Her optimal utility ( VbT ) without the real estate can be
expressed as the followings,

)}

~
VbT (wb ) = max E P ( S~ ) exp b ( wb R + ( ST RS 0 )) .

(7)

Alternatively, if she decides to invest in the land, she bids for the land at a price of kPb . If her
price is accepted by agent A, she would become the new land owner and can decide about the
optimal size of the property to be built on the land q(k )* at time 0. Her maximal utility in this
scenario VbL is shown as
VbL (wb kPb , k ) = max E P ( S~

~
,YT )

{ exp[ ((w
b

)]}

~
~
kPb ) R + ( S T RS 0 ) + q ( k ) * YT C ( q ( k ) * ) . (8)

Although we do not explicitly examine the financing implications in our model, our
results are generally applicable to the situation with financing frictions. In our setting, we can use
the difference in initial wealth, risk aversion or construction cost to proxy for different financing
costs. In reality, the wealthier agent can have better and cheaper access to financing and the
financially constrained agent is likely to have higher risk aversion and incur lower cost.

IPA for Real Estate in Complete Market

We solve for the equilibrium prices of the real estate for agents A and B in complete market
setting. The price of the land is the present value of a real option derived from the investment
outcome to develop a property on the land from time 0 to time T. Market completeness implies
that there are only two market states with two traded financial assets: riskless and risky ones. In
binomial setting, it implies that there are only two outcomes of payoffs, i.e. {YTu , STu } when both
move upwards and {YTd , STd } when they move downwards8.

Market completeness can also be represented by the alternative two payoffs, {YTd , STu } when the market moves
upwards, and {YTu , STd } when the market moves downwards. For brevity we focus on only the first two outcomes in
the text from now onwards.

Proposition 1: In a complete market, agent As lowest ask price Pa and agent Bs highest bid

price Pb are identical. The equilibrium prices are same as the risk-neutral equilibrium option
price that is independent of individual agents risk preferences,
Pa = Pb =

[ (

)]

1
~
E q *YT C (q * ) ,
Rk

(9)

where q * is defined in equation (5), and E is the expectation operator with probabilities and

1 , where =

RS0 STd 9
.
STu STd

The probabilities and 1 in equation (9) are same as the Cox-Ross-Rubinstein risk-neutral
probabilities (Cox, Ross, and Rubinstein, 1979). The bid and ask prices converge to one
equilibrium price that is independent of individuals risk preferences or real probabilities.

IPA for Real Estate in Incomplete Market

Since the real estate market is far from complete, the real world applicability of the previously
obtained real estate prices is debatable. First, the above-mentioned assumption of perfect positive
correlation between the payoffs of real estate and financial asset is often violated in reality (e.g.,
Ibbotson and Siegel, 1984; Green, 2002; Davidoff, 2007). Second, real estate investors often
need to bear large amount of nondiversifiable idiosyncratic risk because the unique
characteristics of real estate offer different investors different investment opportunities, making it
difficult to implement the standard option pricing technique (Williams 1993, 1998; Aguerrevere,
2003; Garmaise and Moskowitz, 2003). Moreover, real estate asset sizes are much bigger and
transaction costs are much higher than those in financial asset transactions.
Using the same economic setting as before, we now relax the assumption of market
completeness. The potential payoff outcomes for real estate and risky financial asset at time T
can be written as ( STu , YTu ), ( STu , YTd ), ( STd , YTu ), and ( STd , YTd ) . The real conditional probabilities
of outcome YT on ST are pu|u , p d |u , pu|d and p d |d , where pu|u is the conditional probability
of payoff (YTu | STu ) , p d |u is the conditional probability of payoff (YTd | STu ) , pu|d is the
conditional probability of payoff (YTu | STd ) , and pu|d is the conditional probability of payoff
9

See detailed proof in Appendix A.1.

(YTd | STd ) . Using similar terminologies as in the complete market setting, we present the

solutions for real estate bid and ask prices in incomplete market setting in the following

Proposition 2 by taking into consideration of heterogeneous risk aversions, nondiversifiable

idiosyncratic risk, and nonsynchronous market comovement.
Proposition 2: In incomplete market, the reservation ask price for agent A can be expressed as

Pa =

( (

1
ln Q exp a q*YT C ( q* )

a Rk

)) ST

(10)

and agent B's reservation bidding price satisfies the following equation

Pb =

( (

1
ln Q exp b q*YT C ( q* )

b Rk

)) ST ,

(11)

where q * is defined in equation (5), Q is the expectation operator under probabilities Q1 , Q2 ,

Q3 , Q4 , Q1 = p u|u , Q2 = p d u , Q3 = (1 ) p u d , Q4 = (1 ) p d d , and =

RS0 STd 10
.
STu STd

Unlike in the complete market setting, the four probabilities Qi , i = 1, , 4, under the
expectation operator Q are dependent on real conditional probabilities such as p u u , p d u , p u d ,
and p d d . In addition to the price determinants identified in the complete market setting, agents
heterogeneous risk aversions also enter into the pricing functions for the real estate. While a
unique pricing kernel exists in the complete market setting, there is none in incomplete market as
risk neutral probabilities are replaced with these new conditional probabilities. In effect, we can
find that in incomplete market, the presence of risk aversion, nondiversifiable idiosyncratic risk,
and market comovement become additional important price determinants for the real estate.
Consistent with Elliott and van der Hoek (2009), to make the bid and ask prices here
comparable to those from the complete market setting, we approximate the prices from

Proposition 2 by the following functional form,

Pi

1
Rk

* 
*
* 
*



Q q YT C ( q ) ST 2 Q VarQ q YT C ( q ) ST ,

where i=a and b, and

10

The proof of Proposition 2 is similar to that of in Musiela and Zariphopoulous (2004) study.

10

(12)

[ (

)]

2
QQ Q Q
~
~
Q VarQ q *YT C ( q * ) ST = ( 1 2 + 3 4 ) q * (YTu YTd ) .

(13)

Equation (12) shows that both the bid and ask prices consist of two components. The first
component can be viewed as a risk-neutral price. The second part is the compensation for
nondiversifiable idiosyncratic risk, shown in equation (13). This additional risk premium is
affected by the coefficients of risk aversion a and b , the real conditional probabilities of state
occurrences Qi , i=1, , 4, and the risk of the real estate payoff (YTu YTd )2 .
The real estate bid and ask prices are the difference between the risk-neutral price and the
idiosyncratic risk premium for agents B and A, where the two premiums differ by the
coefficients of the agents risk aversions, a and b . It is worth noting that while here the risk
neutral price conceptually has the same form as in Proposition 1, the realized price is different
because the CRR risk neutral probabilities are replaced with the real conditional probabilities.
The idiosyncratic risk premium will converge to zero if the agents are no longer risk averse
( a = 0 and b = 0 ), or if the idiosyncratic risk disappears, or if the two random payoffs ( ST
and YT ) are perfectly correlated. The latter two situations can occur when (YTu YTd ) = 0 or if Q1
or Q2 equals to zero, and Q3 or Q4 equals to zero. 11

III. The Relationships between Real Estate Price and Expected Financial Asset Risk and
Return
In this section, we employ comparative static analyses to determine the relationships between
real estate price and the expected financial asset risk and return. First, we present the
conventional pricing relationships in complete market. Then we show that the price-return and
price-risk relationships are conditional on risk aversions, nondiversifiable risk and
nonsynchronous market comovement.

Pricing Relationships in Complete Market

11

There is growing literature in finance that shows that idiosyncratic risk can predict future stock returns (e.g., Ang,
Hodrick, Xing, and Zhang, 2008; Ang, Hodrick and Zhang, 2006; Bali, Cakici, Yan, and Zhang, 2005; Ball and
Cakici, 2008; et al.). These findings imply that there is non-zero relationship between return and idiosyncratic risk.
Avramov, Cederburg and Hore (2010) also provide some theoretical support for this non-zero relationship.

11

Proposition 3: In complete market, the real estate price decreases with the expected risky

financial asset return and increases with the expected risky financial asset risk.12
The real estate price decreases with the expected financial asset return because when the
real estate and the risky financial asset future payoffs are perfectly positively correlated, the
higher payoff from the financial asset makes the real estate less attractive. Since all assets in a
complete market should have same expected returns, the current real estate price should be
reduced ceteris paribus in equilibrium. Moreover, when the expected financial asset risk
increases, the real estate becomes more attractive and its current price should increase. Note that
in this Proposition 3, there is no relationship between real estate price and individuals risk
preferences or real probabilities (e.g., pSu or pSd ). Overall, in complete market, the current real
estate price decreases with the expected return and increases with the expected risk of the risky
financial asset.

Pricing Relationships in Incomplete Market

Using the closed-form solutions for real estate bid and ask prices in equation (12), we also
conduct comparative statics analysis on the price-return and price-risk relationships between real
estate and risky financial asset. In particular, we focus on the pricing implications of investor risk
aversion, idiosyncratic risk, and market comovement. We re-write the first part of the equation
(12) in the following expression:

) (
+ ( p

uu
ud
Q q *YT C ( q * ) ST = p + (1 ) p
du

+ (1 ) p

dd

)(q Y
)(q Y
*

u
T

C (q* ) )

d
T

C (q* ) ) ,

(15)

and the second part of the equation (12) in the following expression:

Q VarQ q*YT C ( q* ) ST

= p p
uu

du

( q*YTu q*YTd ) + (1 ) p p
2

ud

dd

( q*YTu q*YTd ) .
2

(16)

After substituting equation (15) and equation (16) into equation (12) and conducting comparative
statics, we state the results in the following Proposition 4.

12

Proof in Appendix A.2.

12

Proposition 4: In incomplete market, the real estate ask (bid) price decreases with agent As

(Bs) risk aversion and with idiosyncratic risk. However, the real estate prices can increase or
decrease with the expected return and risk of the risky financial asset.13
The first part of the results in Proposition 4 that is consistent with Miao and Wangs (2007)
and Hugonnier and Morellecs (2007) findings, is in stark contradiction with those from the
standard real options literature in complete market (Titman, 1985). The second part of the results,
the key finding in our study, implies that market incompleteness distorts the monotonic price-risk
and price-return relationships found in Proposition 3. The relationships between the real estate
price and risk and return of financial asset can be positive or negative, depending on the
investors risk aversions (a and b), idiosyncratic risk ( ( q*YTu q*YTd ) ), risk neutral probability ,
2

and four conditional probabilities pu|u , p d |u , pu|d , and p d |d in mathematical forms as highlighted
in equations (15) and (16).
We further interpret the last result from Proposition 4 by specifically examine three
important elements of the market incompleteness: risk aversion, nondiversifiable idiosyncratic
risk, and nonsynchronous assets payoffs. In the first step, we conduct comparative statics
analysis. 14 Our results show that the conventional monotonic price-return relationship is not
distorted by risk aversion, but the price-risk relationship may be distorted by risk aversion
depending on the parameter values of the four conditional probabilities pu|u , pd |u , pu|d , and pd |d .
While the price-risk relationship is not related to the idiosyncratic risk by assumption, the pricereturn relationship may be distorted by nondiversifiable idiosyncratic risk depending on the
parameter values of the four conditional probabilities pu|u , pd |u , pu|d , and pd |d . Hereafter, we
relate the four conditional probabilities to the nonsynchronous comovement between real estate
and financial asset because the probabilities are directly one-to-one mapped to the correlation of
the assets payoffs.

IV.

Simulation and Empirical Analysis of Real Estate Price and Expected Financial
Asset Risk and Return Relationships

13
14

See proof in Appendix A.3.

We show comparative statics results in appendix A.3.

13

Our theoretical findings are especially relevant in view of the recent subprime crisis, where the
housing market and equity markets tend to strongly comove. Contrary to expectations and past
empirical evidence that show insignificant and even negative comovement between the real
estate and financial markets in the United States and Europe (e.g., Ibbotson and Siegel, 1984).
While Miao and Wang (2007) show that market imperfection, such as idiosyncratic risk and risk
aversion results in lower asset prices, the role of market comovement is not examined in their
setting, probably because there is no direct link between market incompleteness and market
comovement in theory. In the followings, we use simulation and empirical data to analyze the
complicated price-return and price-risk relationships between real estate and financial asset.

Simulations results for Real Estate price change in incomplete setting

In Fig. 1, we show graphical representation of simulated change in real estate price in response
to the change in expected financial asset return conditional on the three factors of market
incompletenessrisk aversion, nondiversifiable idiosyncratic risk, and market comovement.
With realistic parameter values, Panel (a) of Fig.1 shows that the real estate bid price always
increases with financial asset return and risk aversion coefficient while holding idiosyncratic risk,
the total risk of real asset, the financial asset risk, and the market comovement constant.15 Panel
(b) of Fig.1 shows that the bid price always decreases with the financial asset return and
idiosyncratic risk while keeping the bidders risk aversion, the real estate return, the financial
asset risk (i.e., systematic risk), and comovement constant. 16 More importantly, Panel (c) of

Fig.1 shows that the decline in bid price with financial asset return is affected by the conditional
probability pu|u while holding the bidders risk aversion, the real estate return, the idiosyncratic
risk, and the financial asset risk constant. Panel (d) shows that comovement is related to the
conditional probability pu|u from Panel (c) as pu|u is one-to-one mapped to the comovement.
Overall, Fig.1 shows that with realistic parameter inputs, the negative price-return are not

15

The real estate expected payoff is fixed at 1.8 while the idiosyncratic variance and total variance of the real estate
are 1.464 and 1.56 respectively. The (systematic) variance of the risky financial asset is 0.1536 and the correlation
coefficient of the payoffs is 0.1961 (comovement proxy). To allow for the change in up payoff of the financial
asset and bidder risk aversion, we solve for the down payoff of the financial asset to keep the rest constant.
16
The bidders risk aversion is fixed at 2, the (systematic) variance of the risky financial asset is 0.1536, and the
correlation coefficient of the payoffs is 0.1961 (comovement proxy), and the expected payoff of the real estate at
1.8. We solve for down payoff of the financial asset and the real estate to keep other parameters constant, as we
allow the up payoff of the financial asset and the real estate to change freely in this simulation.

14

distorted by risk aversion and idiosyncratic risk. However, the linear price-return relationship
between real estate becomes nonlinear depending on the market comovement.
[Fig.1 about here]

Fig.2 presents the interaction of real estate bid price and financial asset risk in conjunction
with risk aversion, idiosyncratic risk, and comovement. Panel (a) of Fig.2 shows that the bid
price decreases with financial asset risk independent of risk aversion ceteris paribus.17 Panel (b)
also shows that the bid price always decreases with financial asset risk at any levels of
idiosyncratic risk.18 However, Panel (c) of Fig.2 shows that the bid price can increase or decrease
with financial asset risk depending on the conditional probabilities.19 Since Panel (d) shows that
the conditional probability is one-to-one mapped to the comovement20, we interpret the results in
Panel (c) in terms of comovement. In weak comovement, real estate price decreases with
financial asset risk whereas in strong comovement, the price initially increases with the risk and
decreases after some threshold.
[Fig.2 about here]
To highlight the non-monotonic relationship between real estate bid price and financial asset
risk in conjunction with market comovement, Panel (a) of Fig.3 presents two snapshots from the
simulation graphs in Panel (c) of Fig.2. It reveals a nonlinear relationship showing that the initial
price increases with the risk is followed by a price decline when market comovement is strong
(i.e., when correlation is 0.65). On the other hand, bid price strictly decreases with the risk in

17

We fix the expected payoffs of the real estate and the risky financial asset at 1.8 and 1.18, respectively. The
idiosyncratic risk of the real estate is fixed at 1.464 while the correlation of the real estate and risky financial asset
payoffs is 0.1961 (comovement proxy). To allow for the up payoff of the financial asset and the bidders risk
aversion to change freely in this simulation, we solve for the down payoff of the financial asset and the up-anddown payoffs of the real estate to keep the expected payoff of the financial asset and the real estate and the
idiosyncratic risk fixed.
18
The bidders risk aversion is fixed at 2, the expected payoff of the real estate and the financial asset at 1.8 and 1.18,
respectively and the correlation coefficient of the real estate and risky financial asset payoffs is 0.1961
(comovement proxy). We allow the up payoff of the financial asset, the idiosyncratic risk and the total risk of the
real estate to change freely in this simulation. The down payoff of the financial asset, the up and down payoffs of
the real estate, and the conditional probability P(YTu | STu ) are solved to keep the expected payoff of the financial
asset, the expected payoff of the real estate, and the correlation coefficient constant.
We fix the bidders risk aversion at 2, the expected payoff of the real estate at 1.8, the idiosyncratic risk of the real
estate at 1.464, the (systematic) variance of the risky financial asset at 0.1536. We allow the up and down payoffs
of the financial asset, the up and down payoffs of the real estate, and the conditional probability to change in this
simulation.
20
In appendix A.4, we show that the covariance of the two random payoffs is a direct function of the conditional
probabilities of the payoffs of the real estate depending on the payoffs of the risky financial asset.
19

15

weak comovement (i.e., when correlation is 0.10). 21 The simulation results suggest that real
estate price declines with the risk when comovement is weak as the hedging potential of
financial asset is relatively insignificant. However, when the correlation is high, despite the
increase in the total real estate risk as a result of increasing financial asset risk, the hedging
benefit of the financial asset can offset the negative price impact due to the small increase in the
total risk. But eventually, as the total risk dominates the hedging benefit, the price starts to
decrease with the financial asset risk.
[Fig.3 about here]
Panel (b) of Fig.3, show that the risk-neutral bid price strictly decreases with the financial
asset risk. Panel (c) shows clearly that the nonlinear relationship in Panel (a) is driven by market
incompleteness, as the price compensation for market incompleteness is nonlinear in financial
asset risk. Our simulation results from Fig.2 and Fig.3 show that with realistic parameter inputs,
the pricing relationship between real estate price and financial asset risk are not distorted by risk
aversions and idiosyncratic risk ceteris paribus even though comparative static analysis shows
ambiguous mathematical results (e.g., see Proposition 4). However, the linear and monotonic
pricing relationship can be significantly distorted by nonsynchronous market comovement. The
real estate price can increase or decrease with financial asset risk depending on the sign and
strength of market comovement. These findings can offer a new explanation for the recent
subprime crisis in the United States, showing that an increase in financial asset risk can
accelerate the collapse of the real estate prices after an initial price bubble as the equity market
and the housing market increasingly comove.

International Empirical Analysis of Real Estate Price and Returns

We empirically test our model predictions using international real estate data. Since real estate
transaction price data is not widely available, in most of our empirical analysis, we replace real
estate price with real estate market overall index return and examine the relationships between
real estate return and expected financial asset risk and return. Intuitively, the current real estate
21

We wanted to adopt comovement conditions that are realistic yet different. We find that in normal market
condition, the comovement is weak in the United States (with correlation of 0.1 between real estate and financial
asset market returns), while in pessimistic market the comovement strengthen (correlation is about 0.5). Our
empirical computation based on the correlation between by the quarterly returns of the MIT/CRE transaction
based index return and the value-weighted market index in U.S. from 1984 to 2006 ranges from 0.16 in low
volatility period and 0.5 in high volatility period. Our simulated result are not sensitive to the choice of these exact
correlation numbers.

16

price (at time t) is negatively related with the expected return from time t to t+1, and thus our
model predictions are the opposite if we use the expected return as our dependent variable.
Hence, instead of testing whether real estate current price decreases (increases) with expected
financial asset return (risk) in complete market setting, we test whether real estate expected
return increases (decreases) with expected financial asset return (risk). We use realized return to
proxy for expected return assuming that return process follows a martingale process. We
measure the returns of real estate and financial asset over the same time horizon. In addition, we
also test whether market comovement distorts the linear relationship between real estate return
and financial asset risk and return.
We conduct our empirical analysis in two steps. First, we examine whether the real estate
market is complete using a simple Capital Asset Pricing Model (CAPM) specification,
ERtre = + ( Rtm Rt f ) + tm ,

(17)

where ERtre is the excess return of the real estate index at time t, Rtm is the return of the equity
index at time t, Rt f is the risk free rate at time t, and tm is the equity market volatility at time

t.22 If CAPM holds, the regression model in equation (17) predicts that the intercept should be
zero, the coefficient should be statistically significant, and the coefficient should be close
to zero (Lintner, 1965). If in the first step, we reject the applicability of the simple CAPM model
in the data, we can proceed to the second step and test whether market comovement distorts the
conventional relationships between real estate return and expected financial asset risk and return
with the following specification:
ERtre = 1 + 2 Lowt + 1 ( Rtm Rt f ) + 2 Lowt 1 ( Rtm Rt f ) + 1 tm + 2 Lowt 1 tm ,

(18)

where Lowt-1, a dummy variable, captures low (or weak) market comovement at time t-1.23
With the above specification we test the following model implications:
22

re

Equation (17) is an approximation of our model implication, where the real estate price at time t Pricet is a
function [] of future financial asset risk and return at time t+1, specifically Pricetre = [( Rtm+1 Rt f+1 ), tm+1 ]

23

.
To avoid the triviality, we use the return information from time t-1 to time t, but we use the comovement between
the real estate index and financial asset measured at time t-1. The implicit assumption here is that the comovement
does not vary from time t-1 to t. We also conduct the robustness checks by using an alternative regression model
where the dummy variable Lowt equals to 1 when the equity market volatility is in the bottom 30% percentile, 0
otherwise. This alternative definition is also consistent with empirical findings where the market comovement is
high when volatility level is high (Andersen, Bollerslev, Diebold, and Labys, 1999). The findings are consistent
under this alternative definition of the variable Lowt.

17

H1: In weak comovement the linear positive relationship between real estate return and
financial asset return is distorted.
H2: In weak comovement the linear negative relationship between real estate return and
financial asset risk is distorted.
Hypothesis 1 predicts that 1 > 0 and 2 < 0 whereas hypothesis 2 predicts that 1 < 0 and

2 > 0 in equation (18).

Given the fact that most countries only have quarterly or yearly real estate market data, we
select those countries with monthly series to increase the statistical power of the test. This data
selection process narrows the data to four countries. Table 1 summarizes the source and coverage
information for the four sample countries: Hong Kong, New Zealand, the United Kingdom, and
the United States from 1991 to 2010. We use real estate return proxied by the change in the
monthly real estate market index. 24
At the monthly frequency, we compute the return of the leading equity index from each
country, and calculate the monthly volatility of equity index return from daily return to proxy for
the financial asset risk. Moreover, we also collect risk free interest rate from the Central Banks or
government websites for Hong Kong, New Zealand, and the United Kingdom. For the United
States, the stock market return is the S&P500 index return and the risk free rate is the short term
rate from Kenneth Frenchs website. Lastly, if the real estate and the equity market move in the
same direction (if the indices experience and increase or decrease at the same time) in month t-1
then we define it a strong comovement environment with the dummy variable Lowt-1 equal to 0
otherwise it is a weak comovement environment with Lowt-1 equal to 1.
[Table 1 about here]
We also obtain 12-year public land auction data from Singapore government from 1992 to
2005 to conduct a direct test for the price-return and price-risk relationships implied from

Proposition 4. The vacant land is released for auction by two local government agencies, the
Urban Redevelopment Authority (URA) and the Housing and Development Board (HDB). We
also obtain information about the land, such as land size, unit price (square foot), length of
transaction period are available. To address the concern that the government may time the
24

Given the concern about the stationarity of the real estate index, we first remove the time trend of all the
dependent variables if it exists. We find that only the United Kingdom index return contains significant time trend.
So we conduct the analysis based on the residuals by removing the time trend in the data from the United
Kingdom.

18

market by releasing the land only in favorable market conditions, we verify that the land release
over time is relatively stable as the number observation (i.e., number of parcels put up for
auction) evenly distributed across time. 25 Since the transaction data can come from different
time of the month, we use cluster regression methods in Petersen (2009) by clustering the month
of the land transaction. We also control for the interest rate movements and foreign exchange
rate returns in the regression analysis for Singapore as the prices can be affected by these
macroeconomic variables.
[Table 2 about here]
The results of our first analysis testing the applicability of CAPM in the five real estate
markets are presented in Table 2. The intercept is statistically significant for Hong Kong and
Singapore. The coefficient is only significant for the New Zealand at 10% significance level
while the coefficient is significant only for Hong Kong. It is interesting to note that the
conventional linear relationships between real estate price and financial asset risk and return is
somewhat evident only is small economies (e.g., New Zealand and Hong Kong) where the stock
market and real estate market are expected to strongly comove (Quan and Titman, 1999).
Overall, the results in Table 2 suggest that the simple CAPM in equation (17) is not applicable
for real estate market in any of the five countries and we can reject the null hypothesis that the
realistic price-return and price-risk relationships are linear.
Next, we proceed to examine the impact of market comovement on the usual relationships
between real estate return and the expected risk and return of the financial asset. Table 3 shows
that the positive relationship between real estate returns in Hong Kong, New Zealand and the
United Kingdom becomes less positive and may even become negative whereas the negative
relationship between real estate return and financial asset risk becomes less negative in weak
market comovement. The results from the United States are slightly weaker. The last column in
Table 3 shows that the land price in Singapore is less negatively (may even become positively)
related to the financial market return in weak comovement. However, the price-risk relationship
is insignificant at zero in both strong and weak market comovement periods. The latter finding
can be a plausible outcome of continuous strong economic growth in Singapore during our

25

For more details on the land auction market and pricing efficiency in the Singapore land auction market, please
refer to Ooi and Sirmans (2004) and Ooi, Sirmans and Turnbull (2006).

19

sample period. The strong market comovement gives little power to separate the relationship into
real low and high comovement periods.
[Table 3 about here]
Overall, our empirical analysis suggests that it is important to consider the pricing
implications of market incompleteness internationally. Our results can be interpreted as evidence
that market comovement distorts the conventional positive (negative) relationship between real
estate price and expected financial asset return (risk). Specifically, we reveal that the relationship
between real estate price and financial asset risk is nonlinear and non-monotonic conditional on
market comovement.

V.

Conclusion

In this study, given the uniqueness of real estate, we adopt the indifference pricing approach
(IPA) to price real estate in conjunction with financial asset in incomplete market setting. We
account for market incompleteness by incorporating heterogeneous risk aversions, idiosyncratic
risk, and nonsynchronous market comovement. Since in the theoretical model the relationships
between real estate price and expected financial asset risk and return are undetermined in the
presence of market imperfections, we adopt realistic model parameters and conduct simulations
to provide further insight into real estate pricing. The simulation results show that while risk
aversions and idiosyncratic risk are unlikely to distort the conventional linear relationships
between real estate price and expected financial asset risk and returns, the market comovement
can significantly distort these relationships.
The recent near-collapse of the US housing and equity markets implies strong positive
correlation between the two markets. This can leave investors under-diversified or overexposed
to systematic risk. Our findings suggest that in incomplete market the real estate price can
increase with the financial asset risk when the risk is low and decrease with the risk when the
risk is high. Hence, investors can be surprised by the initial price rally and eventual price reversal
when market comovement becomes stronger. Moreover, the usual positive price-return
relationship can also be reversed once market comovement changes. Our cross-country empirical
analysis provides further support for our theoretical conjecture.
Overall, our study suggests that investors should evaluate the characteristics of real estate
market carefully before constructing a seemingly diversified investment portfolio, because real
20

estate price can unexpectedly rise or decline with increase in financial asset return or risk under
certain conditions. The heterogeneous risk aversions, the nondiversifiable idiosyncratic risk and
the degree of market comovement can have important pricing implications on real estate when
risky financial asset can only provide partial hedging benefits.

21

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25

Table 1 Data Description

With the exception of Singapore, the monthly residential real estate index values and the change in the index value
as a return measure obtained from four national markets, Hong Kong, New Zealand, U.K., and U.S. In case of
Singapore, real estate price data from land auction transactions are collected for 1992 to 2004. Besides real estate
indices, national stock exchange index values, and risk free rate measures are collected from the relevant markets.
For Hong Kong, New Zealand, U.K., and Singapore the risk free rate information is obtained from the Central
Banks or government websites, while for the United States the risk free rate is the commonly used information in
asset pricing models and obtained from Kenneth Frenchs website at Dartmouth college.
Hong Kong

New Zealand

United Kingdom

United States

Singapore

Real Estate
index/price

HKU Pricing
Index

Housing Price
Index

Housing Price
Index

Housing Price
Index

Land Price

Equity Index

Hang Seng

NZ index

FTSE

S&P 500

Straits Times

Risk-free rate

3-month Tbill

3-month Tbill

Short-term Gilt

Risk Free Rate

From Kenneth French 3-month Tbill

Time Period Jul 1991 - Jan 2010 Jan 1992 - Feb 2010 Jan 1991 - Jan 2010 Jan 1992 - Dec 2008

26

1992-2004

Table 2 Regression Analysis Results of National Real Estate Price Indices and Real Estate Transaction Price
The dependent variables are the monthly returns on the national residential property index for Hong Kong, New
Zealand, the United Kingdom and the United States. In Singapore, the dependent variable is the logarithm of the unit
price of in the land auction. The Excess Equity Ret is the difference between the monthly return of the national stock
index and the risk free rate. Equity Vol is the monthly standard deviation of the volatility of the stock index returns.
We control for the time trend in the United Kingdom residential property index return. We also control for the
interest rates for Singapore land price data, and use clustered regression by month. We report coefficient estimated
with the corresponding t-values and use ***, **, and * to denote significance at the 1%, 5%, and 10% level (twosided), respectively.
Hong Kong
Intercept

New Zealand United Kingdom

United States

Singapore

0.016
3.72***
-0.005
-0.190
-0.977
-4.02***

0.001
0.460
0.040
1.94*
-0.130
-0.510

0.001
0.77
0.008
0.400
-0.001
-0.870

0.0014
0.22
0.0126
0.15
0.0917
0.16

8.083
40.32**
0.409
0.430
3.783
0.29

Other Control Variables

No

No

Yes

No

Yes

Adjusted R-squares
Number of Observations

0.064
223

0.010
218

-0.003
229

-0.010
216

0.020
366

Excess Equity Ret

Equity Vol

27

Table 3 Regression Analysis Results of National Real Estate Price Indices and Real Estate Transaction Price
The dependent variables are the monthly returns on the national residential property index for Hong Kong, New
Zealand, the United Kingdom and the United States. In Singapore, the dependent variable is the unit price of in the
land auction. The Excess Equity Return is the difference between the monthly return of the national stock index and
the risk free rate. Equity Vol is the monthly standard deviation of the volatility of the stock index returns. Low is a
dummy variable represents a weak comovement (i.e., low correlation) between real estate return and equity market
return. It is interacted with both the Excess Equity Return and Equity Vol.. We control for the time trend in the
United Kingdom residential property index return. We also control for the interest rates for Singapore land price
data, and use clustered regression by month. We report coefficient estimated with the corresponding t-values and use
***, **, and * to denote significance at the 1%, 5%, and 10% level (two-sided), respectively.

Intercept
Excess Equity Return
Equity Volatility
Low * Excess Equity Ret
Low * Equity Vol
Low
Other Control Variables
Adjusted R-squares
Number of
Observations

Hong Kong

New Zealand

United Kingdom

United States

Singapore

0.012
2.44***
0.237
7.31***
-1.051
-3.74***
-0.450
-10.4***
0.617
1.60
0.000
0.02
No

0.004
1.84*
0.175
8.12***
-0.412
-1.62*
-0.350
-10.01***
0.493
1.12
-0.006
-1.69*
No

0.002
0.99
0.147
6.32***
-0.003
-1.64*
-0.309
-8.83***
0.004
1.55
-0.003
-1.04
Yes

0.001
0.07
0.522
4.93***
0.750
1.21
-1.072
-6.87***
-0.766
-0.72
0.003
0.22
No

8.065
47.77**
-0.323
-0.330
2.705
0.24
3.581
1.91*
-7.854
-0.25
0.357
1.13
Yes

0.431

0.345

0.314

0.191

0.081

223

218

229

216

366

28

Fig. 1 Simulation Results for the Relationships between the Real Estate Price (Bid Price) and Financial Asset
Return in Conjunction with Risk Measures and Assets Comovement
Panel (a) shows that the relationship between real estate bid price and financial asset return conditional on risk
aversion. Panel (b) shows that the relationship between real estate bid price and financial asset return conditional on
idiosyncratic risk. Panel (c) shows the relationship between real estate bid price and financial asset return in
conjunction with conditional probability. Panel (d) shows that the conditional probability is one-to-one mapped to
asset market comovement. The base parameter values used for the simulation exercise are b=2,
u
u
d
d
d
u
u
R=1.05,Variance(ST)=0.1536 YT = 3.0, YT = 0.5, P(ST ) = 0.6, P(YT | ST ) = 0.6, and P(YT | ST ) = 0.6.

Panel (b)
1.4

0.4

1.2

0.3

Bid Price

Bid Price

Panel (a)
0.5

0.2

0.6

0.1
0
2

0.8

1.9

1.8

1.7

1.1

1.3

1.2

Risk Aversion

1.4

0.4
1.5

1.5

0.5

1.1

Idiosyncratic risk

E(S)

1.3

1.2

1.4

1.5

E(S)

Panel (d)

Panel (c)

Correlation Coefficient

0.4

Bid Price

0.3

0.2

0.1

0
0.9

0.5
0.4
0.3
0.2
0.1
0.9
0.8

0.8

0.7

Prob(Yu|Su)

0.6

0.5

1.15

1.25

1.2

1.3

0.7

1.35

0.6
Prob(Yu|Su)

E(S)

29

0.5

1.15

1.2

1.25
E(S)

1.3

1.35

Fig. 2 Simulation Results for the Relationship between the Real Estate Price (Bid Price) and Financial Asset Risk
in Conjunction with Other Model Parameters
Panels (a), (b) and (c) show that relationship between bid price of the real estate and financial asset risk in
conjunction with risk aversion, idiosyncratic risk, and conditional probability. Panel (d) shows that the asset market
comovement is one-to-one mapped to the conditional probability. The base parameter values used for the simulation
exercise are b = 2, E ( ST ) = 1.18, YTu = 3.0, YTd = 0.5, P(STu ) = 0.6, P(YTu | STu ) = 0.6, and P(YTd | STd ) = 0.6.

Panel (a)

Panel (b)

0.5
0.8
0.6
Bid Price

Bid Price

0.4

0.3

0.2

0.2

0.1
2

0.4

0
2
1.9

1.8

1.7

0.2

0.1

Risk Aversion

0.3

0.4

0.5

1.5
Idiosyncratic risk

Variance(S)

Panel (c)

Correlation Coefficient

Bid Price

0.3
0.2
0.1
0
1
0.8
Prob(Yu|S u)

0.4

0.1

0.2

0.3

0.4

0.5

Variance(S)

Panel (d)

0.4

0.6

0.1

0.2

0.3

0.4

0.8
0.6
0.4
0.2
0
1
0.8

0.5

0.6
Prob(Yu|S u)

Variance(S)

30

0.4

0.1

0.2

0.3

0.4

Variance(S)

0.5

Fig. 3 Simulation Results of Relationship Between Real Estate Price and Financial Asset Risk in Weak and
Strong Market Comovement.
Panel (a) shows two snapshots from Pane (c) in Figure 3. The solid line (dashed line with Y-axis on the right hand
side (RHS)) represents the real estate price and financial asset risk relationship in weak and strong market
comovement (i.e., with payoff correlation of 0.10 and 0.65, respectively). Panel (b) shows the risk neutral portion of
the bid price and Panel (c) shows the compensation portion of the bid price (i.e., Bid price risk neutral price).
Panel (a)

0.26
0.255

Bid Price

0.25
0.245
0.24
0.235
0.23
0.225
0.22

corr = 0.65 (RHS)

0.
15
0.
17
0.
19
0.
22
0.
24
0.
26
0.
29
0.
32
0.
35
0.
38
0.
41
0.
44
0.
47

0.215

corr = 0.10

0.2
0.18
0.16
0.14
0.12
0.1
0.08
0.06
0.04
0.02
0

variance (S)

Panel (b)

1.695

1.56
1.54

1.69
Risk Neutral Price

1.52
1.685

1.5

1.68

1.48

1.675

1.46
1.44

1.67

1.42
1.665

corr = 0.10

1.4

corr = 0.65 (RHS)

1.38

0.
15
0.
17
0.
19
0.
22
0.
24
0.
26
0.
29
0.
32
0.
35
0.
38
0.
41
0.
44
0.
47

1.66

variance (S)

Panel (c)

1.46

1.4
1.38

1.45

1.36

1.44

1.34

1.43
1.32

1.42

1.3

1.41
1.4

corr = 0.10

1.28

corr = 0.65 (RHS)

1.39

1.26

0.
15
0.
17
0.
19
0.
22
0.
24
0.
26
0.
29
0.
32
0.
35
0.
38
0.
41
0.
44
0.
47

Compensation for Market Incompletess

1.47

variance (S)

31

Appendix A
A.1

Proof of Proposition 1

Suppose that agent A keeps the land and maximize his utility by choosing the optimal investment
strategy given the optimal construction size q * . Differentiating equation (4) with regard to
gives

(S

u
T

d 1
T

(
(

)
)

pSu ( STu RS0 ) exp a ( q*YTu C (q* ) )

ln d
pS ( RS0 STd ) exp a ( q*YTd C (q* ) )

(A1a)

where R is one plus the risk-less interest rate over the one period, and STu S0 > R > STd S0 and
YTu Y0 > R > YTd Y0 hold in order to eliminate arbitrage opportunities. Substituting this result back

into eq. (4) yields the following optimal utility level for the investor
Va* ( wa , k ) = exp a R ( wa )

p u exp q*Y u C (q* ) p d 1 exp q*Y d C (q* )

( S)
) ( S)
)
a(
T
a(
T

(1 )

(A1b)

Alternatively, agent A can sell the land for kPa , and invest all his wealth wa + kPa into x units
of the risk-free asset and units of the risky asset. Differentiating equation (6) with regard to ,
we derive

**

(S

u
T

d 1
T

pSu ( STu RS0 )

.
ln d
d
pS ( RS0 ST )

(A1c)

Substituting equation (A3) into equation (6) produces the optimal utility level

( pu ) ( p d )1
S
S
.
V ( wa + kPa ) = exp a R ( wa + kPa )
(1 )1

(A1d)

According to the definition of indifference ask prices, we have

Va* ( wa , k ) = V * ( wa + kPa ) .

(A1e)

Solving this equation, we can obtain the indifference ask price as follows
Pa

1
ln exp a ( q*YTu C (q* ) ) + (1 ) ln exp a ( q*YTd C (q* ) )

a Rk

1
=
q*YT C (q* ) .
Rk

32

(A1f)

On the other hand, agent B is indifferent between foregoing the vacant land at time 0 and paying
kPb for the land at time T; and thus, we can obtain the bid price for the land as
Pb

1
ln exp b ( q*YTu C (q* ) ) + (1 ) ln exp b ( q*YTd C (q* ) )

b Rk

(A1g)

1
( q*YT C (q* ) ) .
=

Rk

Q.E.D.

A.2

Proof of Proposition 3

The mathematical implications for the Proposition 3 are represented in the following
comparative statics results. We find that,

P P
Pa Pb
Pa
P
= u < 0,
= bd < 0 , and a = b > 0 .
u
d

ST ST
ST ST

Differentiating equation (9) produces the following derivatives

RS0 STd )( q*YTu q*YTd )
(
Pa Pb
=
=
<0
2
STu STu
Rk ( S u S d )

(A2a)

STu RS0 )( q*YTu q*YTd )

(
Pa Pb
=
=
<0
2
STd STd
Rk ( STu STd )

(A2b)

We use to represent the increase of the risk of the risky financial asset. If we increase STu by

, to keep the expected value of ST the same, we need to reduce the payoff STd by pu / p d .
dPa dPb
d * u
1 d * u
d * d
=
=
q YT C (q* ) )
q YT C (q* ) ) =
q YT q*YTd ) > 0
(
(
(

d d Rk d
d
d

(A2c)

psu u
d
p d ( ST RS0 ) ( RS0 ST )
u u
d d
d s
= ( ps ST + ps ST RS0 ) > 0,
where
=
2
2
d
u
psu
psu
d
d u
d
ps ST ST + (1 + d )
ST ST + (1 + p d )
ps
s

since psu STu + psd STd > RS0 by assumption that stock is riskier than riskless asset.

Q.E.D

33

A.3

Proof of Proposition 4

The prices of the land in the incomplete market setting with a risky hedging financial asset are
expressed in the following equations.
Pi =

a Rk

( (

ln Q exp i q*YT C (q* )

(
)
2
QQ Q Q
1
[(Q1 + Q2 ) ( q*YTu C (q* ) ) + (Q3 + Q4 ) ( q*YTd C (q* ) ) i ( 1 2 + 3 4 ) ( q* (YTu YTd ) )
=
2
1
Rk
1
uu
ud
du
dd
[ p + (1 ) p ) ( q*YTu C (q* ) ) + ( p + (1 ) p ) ( q*YTd C ( q* ) )
=
Rk (
2

uu du
ud dd
i ( p p + (1 ) p p ) ( q*YTu q*YTd ) ]
2

1
Rk

)) ST

*
* 
*
* 

Q q YT C (q ) ST 2 Q VarQ q YT C (q ) ST

The mathematical implications for the Proposition 4 are represented in the following
comparative statics results after differentiating the above pricing equations.
Pa Pb
dP
dP
P > P > P > P >
dP >
=
< 0 , a < 0 , b < 0 , au 0 , bu 0 , ad 0 , bd 0 , i 0.
a b
dz
dz
ST < ST < ST < ST <
d <

Pa
1
=
Q VarQ q*YT C ( q* ) ST < 0

2 Rk
a

(A3a)

Pb
1
=
Q VarQ q*YT C (q* ) ST < 0

b
2 Rk

(A3b)

~
In order to change the volatility while keeping the expected mean of the random variable YT

unchanged, we introduce the variable z to represent the increase in YTu , whereas decrease YTd by

z pu u + (1 ) pu d

) ( p

du

+ (1 ) p d d at the same time. Hence, z represents the change in

the nondiversifiable idiosyncratic risk of the real asset. Substituting these changes into equation
(12) and then differentiating the resultant equation, we obtain the following results.
Let hu = p u u + (1 ) p u d and h d = p d u + (1 ) p d d . Then the following derivatives can be
produced
dPi
p p
= i
dz
Rk
uu

du

u
* u
* u

( q YT q*YTd ) + q* z 1 + hhd q* + qhhd

i (1 ) p u d p d d
Rk

hu
* u
* d
*
( q YT q YT ) + q z 1 + d
h

34

* q*hu
q + d
h

<0

(A3c)

p
Pi
Pi
=

+
STu
( STu STd )

ud

(q Y
*

u
T

C (q* ) ) + p

dd

Rk ( STu STd

(q Y
)
*

d
T

C (q* ) ) i p p ( q*YTu q*YTd ) >

0

<
2Rk ( STu STd )
ud

dd

pu u ( q*YTu C(q* ) ) + pd u ( q*YTd C(q* ) ) i pu u pd u ( q*YTu q*YTd ) >

Pi
Pi
=

+
0
STd ( STu STd )
<
Rk ( STu STd )
2Rk ( STu STd )

(A3d)

(A3e)

We use to represent the increase of the risk of the risky financial asset. If we increase STu by

, to keep the expected value of ST the same, we need to reduce the payoff STd by pu / p d .
The derivative is shown as the followings:
dPi
d d u d d d * d
1 d u u d u d * u
p
p ( q YT C (q* ) ) +
p
p ( q YT C (q* ) )
[
=
d Rk d
d
d
d

i d u u d u d u d d d * u * d 2 >
(
p p
p p ) ( q YT q YT ) ] 0.
d
<
2 d

We have shown the exact form of

(A3f)

d
in appendix A.2.
d
Q.E.D

A.4

Proof of the Relationship between Conditional Probabilities and Covariance

Structure of Real Estate and Financial Asset

~
~
According to the definition of covariance, we have the covariance of YT and ST as follows

(
(Y

)(
EY ) ( S

) (
ES ) + p (Y

)(
EY ) ( S

Cov = pu|u YTu EYT STu EST + pu|d YTu EYT STd EST
+ pd|u

d
T

u
T

d |d

d
T

d
T

EST

(A4a)

Where pu|u , pu|d , p d |u , and p d |d represent the joint probabilities of the outcomes
(YTu , STu ), (YTu , STd ), (YTd , STu ), and (YTd , STd ). If these two variables have a high positive correlation
(i.e., strong market comovement) that implies small value of pud and p du , we can approximate
the above equation as
Cov pu|u YTu EYT STu EST + pd|d YTd EYT STd EST .
(A4b)

)(

)(

Given that the up and down probabilities of YT and ST remain unchanged and that their
increasing and decreasing proportions are also unchanged, this suggests that an increasing joint
up or down probability of these two variables leads to a greater positive correlation between
these two variables. If these two variables tend to be negatively correlated so that pu|u and pd |d are
very low, this equation can be approximately expressed as follows
Cov pu|d YTu EYT STd EST + pd|u YTd EYT STu EST .
(A4c)

)(

)(

35

Given those conditions remaining unchanged, this suggests that an increase in pu|d and p d |u results
in a greater absolute-value correlation between these two variables. On the other hand, if the
correlation is close to 1, this implies that both pu|d and p d |u are low. Also, both pYu and pSu are close
to each other and to pu|u , and both pYd and pSd are close to each other and to pd |d . Since equation
(10) can be rewritten as

pu|u exp a ( q*YTu C (q* ) ) + p u|d exp a ( q*YTd C (q* ) )

ln

pSu
1

Pa =

a Rk
p d |u exp a ( q*YTu C (q* ) ) + p d |d exp a ( q*YTd C (q* ) )

+ (1 ) ln
pSd

(A4d)

we have the approximate expression

Pa
=

1
ln exp a ( q*YTu C (q* ) ) + (1 ) ln exp a ( q*YTu C (q* ) )

a Rk

1
q*YT C ( q* ) .
Rk

Similarly, given that equation (11) may be rewritten as

pu|u exp b ( q*YTu C (q* ) ) + p u|d exp b ( q*YTd C (q* ) )

ln

pSu
1

Pb =

b Rk
p d |u exp b ( q*YTu C (q* ) ) + p d |d exp b ( q*YTd C (q* ) )

ln
+

)
(

pSd

we can obtain
Pb

1
q*YT C (q* ) .
Rk

36

(A4e)