Essays in financial economics and contract theory

The dissertation consists of three essays, two in financial economics and one in contract theory. In the first essay, a one-factor pricing model is employed to investigate the total returns of single-family homes and professionally-managed properties during 1986-2006. Portfolios of East and West Coast cities have negative risk-adjusted returns, while a portfolio of all inland cities has positive alpha. Positive alphas can be achieved with portfolios of high rental yield cities, small cities, low median price cities, or low beta cities, while the opposite strategies generate negative alpha. However, a momentum strategy does not outperform the US real estate index on a transaction and risk-adjusted basis. A possible explanation for these abnormal returns is that some cities are systematically neglected by investors. In the second essay, I explore the optimal way in which housing derivatives should be used to mitigate housing risk. Households should hedge housing both as investment and as consumption. Housing investment risk is hedged by selling housing futures amounting to the full value of the home. Housing consumption risk is hedged by buying housing futures in each city where the household might move. The size of the hedges depends on the probability of moving and on home values in each city. The hedging demands offset each other when the household lives in the same home indefinitely. This framework can also be used to simplify the rent versus buy decision. In the third essay, joint work with George P. Baker, we examine wage policies that provide incentives to invest in firm-specific human capital, when these investments require non-contractible employee effort. The firm-specific and general investments are substitutes in the employee's utility function, even if they are not in the cost function. The firm-specific investment jumps discontinuously from zero to a positive level as the wage policy is adjusted. The firm can be in one of three possible regimes: stable, fragile, or no profitable wage policy. The model also explains why human resource departments strive to create employee affiliation. Furthermore, we derive closed form solutions for human capital investments and optimal wage policies in a multiple period model.