Trading in the housing market: A model with transaction costs

Abstract

High predictability of returns on housing suggests pervasive irrationality on the part of market participants. In this paper, we show that with small transactions costs, returns may remain highly predictable even if the market contains substantial numbers of risk neutral, rational speculators. The reason is that option values associated with the transactions costs substantially delay arbitrage transactions. Our model can generate positive short-run and negative long-run autocorrelation in returns on housing similar to those identified by past empirical studies.