Asset Pricing with Financial Frictions

In Chapter One, we investigate the role of financial frictions, namely the loan-to-value (LTV) and payment-to-income (PTI) limits, in a New Keynesian dynamic stochastic general equilibrium (NK-DSGE) model, and their impact on expected excess returns to housing. Our findings reveal that a monetary contraction enhances the expected excess return to housing in the presence of collateral and income frictions, as compared to the model without frictions. Monetary policy exerts positive direct and indirect effects on excess returns. Specifically, an increase in the nominal interest rate raises excess returns directly by increasing the shadow value of borrowing and indirectly by amplifying the covariance between future returns to housing and future marginal utility of consumption. Chapter Two conducts an empirical assessment of the response of expected excess return to housing and key macroeconomic variables to monetary policy shocks. Using quarterly data from Canada and a vector autoregressive (VAR) model, we demonstrate that a rise in the overnight rate prompts a decline in key macroeconomic variables, while leading to an increase in excess return to housing. We also investigate the reaction of expected excess return to housing to shocks to LTV and PTI limits. Chapters Three and Four employ recent econometric techniques for the analysis of heterogeneous dynamic panels subject to cross-sectional dependence, to investigate the determinants of real house prices in a panel of 10 Canadian provinces over a period of 22 years. Specifically, we examine the extent to which real house prices at the provincial level are driven by fundamentals such as real per capita disposable income and common shocks, and evaluate the speed of adjustment of real house prices to macroeconomic and local disturbances. The empirical analysis employs modern panel factor models with interactive fixed effects and possible cross-sectional dependence.