Household Hedging Motives and Financial Risk Taking: Evidence from Europe

Abstract: Financial economists have suggested how hedging motives related to human capital and real estate should affect financial risk-taking of a utility maximizing household. Using rich cross-sectional data from the second wave of the Eurosystem Household Finance and Consumption Survey, I analyze how such motives relate to the propensity to participate in the markets for risky assets and the risky share - portion of financial portfolio allocated to the risky assets. By matching households with the long quarterly time series of aggregate labor income on the country-sector level and housing related variables on the country level, I am able to compute key explanatory variables. While some findings are consistent with the normative predictions, several empirical regularities create a puzzle. In particular, effects on the propensity to participate often differ from effects on the risky share of participants. I find that while size of the human capital encourages participation, it makes participants have lower risky shares. Higher correlation between risky asset, proxied by the local equity indices, and labor income discourages participation but has no significant effect on the risky share among participants. Volatility of the labor income also discourages risk-taking. As for housing, renters are less likely to be participants and have smaller risky shares compared to homeowners consistent with expectations. Moreover, as normative theory would suggest, renters have higher risky shares in countries with higher rent risky asset correlation while owners have lower risky shares in countries with higher house price risky asset correlation. At the same time, in terms of participation decision these two relations are reversed. Also surprisingly, prospective house buyers are found to have lower risky shares for higher levels of house price correlation with the risky asset.