Journal of Real Estate Finance and Economics, 27:2, 191±209, 2003
# 2003 Kluwer Academic Publishers. Manufactured in The Netherlands.
Hedging Housing Risk in London
Department of Economics, Boston College, Carney Hall, Chestnut Hill, MA 02467-3806, U.S.A.
FRANCË OIS ORTALO-MAGNE
Department of Economics, London School of Economics, Houghton Street, London WC2A 2AE, U.K.; and
Department of Real Estate and Urban Land Economics, University of Wisconsin, 975 University Avenue,
Madison, WI 53706, U.S.A.
This paper investigates the bene®ts of allowing households to compensate the portfolio distortion due to their
housing consumption through investments in housing price derivatives. Focusing on the London market, we show
that a major loss from over-investment in housing is that households are forced to hold a very risky portfolio.
However, the strong performance of the London housing market means that little is lost in terms of expected returns.
Even households with limited wealth are better off owning their home rather than renting and investing in ®nancial
assets, as long as they are willing to face the ®nancial risk involved. In this context, access to housing price
derivatives would bene®t most poor homeowners looking to limit their risk exposure. It would also bene®t wealthier
investors looking for the high returns provided by housing investments without the costs of direct ownership of
properties. Comparisons with French, Swedish and U.S. data provide a broader perspective on our ®ndings.
Key Words: portfolio risk, house price index, hedging
This paper provides further evidence on the potential bene®ts of ®nancial instruments linked
to the performance of the housing market, using London, England, as a case study. We ®nd
that the returns to housing in London have been strong but very volatile compared to other
®nancial assets. Households overinvested in housing due to their housing consumption
motive gain from the high returns on their home, but are forced to hold a very risky portfolio.
Standard ®nancial assets do not provide much of a hedge against the risk of owning a home.
This explains why homeowners pursuing low-risk±low-return strategies would bene®t from
the introduction of housing price derivatives. We ®nd that the other major bene®ciaries of
such derivatives would be investors pursuing high-risk±high-return strategies.
The ®rst reason for choosing London as the focus of this study is the volatility of the
local housing market since the mid-1970s, the period covered by our data. The second
reason is that Londoners now have access to ®nancial instruments which allow them to
limit or expand their exposure to housing price risk, independently of their housing
consumption. Such instruments have been discussed in the literature for a number of years.
The academic literature has attempted to encourage their introduction by demonstrating