Minimization of potential debt problems
Key to the success of a property derivatives market is the existence of a transparent and reliable index that can be used as an underlying value. Creating such an index for properties is by no means an easy task. No two buildings are identical; i.e. properties are heterogeneous constituents of an index. Consequently, recording and averaging only prices or valuations lead to a poor-quality index. All characteristics of a property that determine its value also need to be considered, so that prices can be adjusted for heterogeneity and finally be aggregated. Most existing indices were initially constructed as descriptive measures, typically targeted as a benchmark instrument. Thus, it is not clear that these indices are suitable as underlying instruments for derivatives, i.e. as operative measures. To achieve a high accuracy and to earn wide trustworthiness, the following basic criteria should be fulfilled:
Representativeness. The index must truly reflect risk and performance of the respective real estate market and idiosyncratic risk should be reduced to an acceptable level by including a large enough number of objects. Just as for the stock market, where an index with a limited number of titles represents the overall market well, a large enough sample represents the property market as a whole.
Transparency. The calculation debt problems method of the index has to be publicly available.
Track record. A long track record helps people to understand the index and to judge its representativeness and behavior in past economic circumstances.
Objectivity and minimization of potential fraud. The input data must be free of subjective preferences and valuation practices. A large number of independent data providers further reduces the risk of manipulation, as the data of each provider gets a smaller weight in the overall index.
Development of the property credit and taxes
The development of the property derivatives market has so far centered on the UK and the US. However, both interest and transaction volumes are growing throughout Europe and Asia. Market participants expect first trades in Denmark, Ireland, the Netherlands, Spain and Sweden after first trades in Australia, France, Germany, Hong Kong, Japan and Switzerland. As the quality of indices improve, more and more countries will see first trades. Also, thePan-European IPD index creates strong interest from retail investors and from US pension funds. The trend is unlikely to spread to some countries where the data basis, needed to construct a reliable index, is insufficient.
Quickly increasing volumes are also expected due to the interest of insurance companies to hedge their liability risk, which depends heavily on real estate price changes. Liquidity will probably only change if more banks are willing to warehouse risks, i.e. take a risky position.
More mature markets will lead to more standardized derivatives traded on exchanges. However, the OTC market is likely to be the dominant derivative format in the near future.
The property group Grosvenor and ABN Amro traded the first property derivative in Australia, based on the Property Council/IPD Australian Property Index, in May 2007. The trade took the form of a two-year total return swap.
Derivatives trading and payday loans
Derivatives trading in the RPX started on 17 September 2007 on an over-the-counter (OTC) basis with maturities expected to be from one to five years. Initially, licensed banks to offer products in the RPX market included Morgan Stanley, Lehman Brothers, Merrill Lynch, Deutsche Bank, Goldman Sachs and Bear Stearns. Trades are quoted in terms of price appreciation in percent for a given maturity date and executed as quarterly price return swaps exchanging a fixed payment against the quarterly index appreciation. For example, if one counterparty buys the index with a maturity of one year at 4 %, he or she pays 1% every quarter in exchange for the actual quarterly index returns.
The interdealer broker ICAP announced the creation of a joint venture with Radar Logic to develop the RPX market in August 2007. In September 2007, ICAP intermediated the first derivative transaction, a total return swap, based on the RPX. The counterparties were two of the licensed banks. Further, Radar Logic has plans to roll out similar indices that allow trading in commercial real estate.
Median prices of home credits
The Chicago Board of Options Exchange (CBOE)’s Future Exchange (CFE) offers futures contracts that track prices nationally and regionally (North-east, South, Midwest and West) and eventually in 10 metropolitan areas as well.
CFE contracts are linked to the median price of existing home sales as tracked by the National Association of Realtors (NAR). Further, HedgeStreet allows anyone with a US$ 100 deposit and an internet connection to trade financial instruments called “housing price hedgelets” based on single-family house prices in six different cities (Chicago, Los Angeles, Miami, New York, San Diego and San Francisco). Just as the CFE contracts, the HedgeStreet hedgelets are based on indices of NAR. CBOE and HedgeStreet announced on 22 February 2006 that they collaborated on retail distribution of their contracts via joint marketing initiatives and that they would share certain technologies and hosting facilities to achieve cost and distribution synergies. The agreement also involved an equity investment by CBOE in HedgeStreet.
Moreover, the London-based International Real Estate Exchange (INREEX) intends to offer contracts tied to average home prices published by the Office of Federal Housing Enterprise Oversight (OFHEO), the agency that regulates the mortgage organizations Fannie Mae and Freddie Mac. The exchange’s trading technology allows investors to trade the national or a state index online.
The low trading volume in the contracts based on the S&P/Case–Shiller index caused Radar Logic, an analytic and data company providing a range of daily indices and analytic tools, to launch a further index family for residential property. The Residential Property Indices (RPX) represent the median transaction prices per square foot paid in one of 25 Metropolitan Statistical Areas (MSAs) on any given day. In addition, there is a national composite index, representing over US$ 10 trillion in residential properties. The RPX market targets investors that are exposed to mortgage credit or to the housing market cycles in general.
Options designed to follow payday loan prices
The Chicago Mercantile Exchange (CME) offers futures and options contracts designed to follow home prices in 10 US cities, as well as an aggregated national index. CME opened trading in contracts based on the S&P/Case–Shiller Home Price indices on 22 May 2006.
CME housing futures and options are cash-settled to a weighted composite index of national real estate prices, as well as to specific markets in the following US cities: Boston, Chicago, Denver, LasVegas, Los Angeles, Miami, NewYork, San Diego, San Francisco andWashington DC. Trading in the housing contracts has been relatively thin in the first year, with an average daily volume of about 50 contracts. The notional value of all outstanding futures contracts was slightly above US$ 77 million in August 2006. In total, the traded notional was approximately US$ 340 million in 2006. In early 2007, volume was still low and only about 25 contracts a day were traded on average. According to the CME, there is a “huge educational need” for this new derivatives market.
Critics say that the design of the contracts has held the market back, as they only go out to one year while most investors want to hedge for longer periods of time. This issue was addressed in September 2007, when the CME extended its contracts on the S&P/Case–Shiller index out to 60 months.
