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.
Cash-settled payday loan contracts are available
After the launch of futures and options on regional home prices, CME announced a partnership with the commercial real estate index provider Global Real Analytics (GRA) on 6 September 2006. They listed future and option contracts based on the S&P/GRA Commercial Real Estate Indices (CREX) on 29 October 2007.
The S&P/GRA CREX indices capture underlying real estate dynamics by tracking transaction-based price changes in diverse property sectors and geographic regions. GRA has a 20-year history of capturing data and sees the new indices as a natural extension, suited for the use of publicly traded futures contracts.
Ten quarterly cash-settled contracts are available: a national composite index, five regional indices (Desert Mountain West, Mid-Atlantic South, Northeast, Midwest and Pacific West) and four national property type indices (retail, office, apartment and warehouse properties).
CME expects the users of the new property contracts to be different from those trading in housing derivatives. If someone hedges against house-price declines in an area, he or she develops or buys a house there. The commercial contracts, on the other hand, are designed for larger investors who hold commercial properties in their portfolios, such as pension funds and REITs.
To hedge real estate or home price declines, individuals can purchase put options based on a particular index. If prices fall, investors will naturally see the value of their real estate holdings decline, but they offset the losses with gains in the put options. The CME hopes that there will be enough speculators in the market to take the other side of the transactions.
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.
The capital credit value components
In early 2007, further banks were granted licences to trade the NCREIF property index and are planning to launch a US platform to trade property derivatives (Four more banks, 2007). By December 2007, seven banks were licensed to trade derivatives on the NCREIF commercial property index. Besides Credit Suisse, Bank of America, Deutsche Bank, Goldman Sachs, Lehman Brothers, Merrill Lynch and Morgan Stanley are involved. The traded volume reached US$ 300 million by late 2007. More banks are expected to sign up for a licence contract within a few months (Banks move, 2007; Property derivatives, 2007). Given the potential, hedge funds and insurance companies are also starting to show interest in developing the US market for property derivatives.
Credit Suisse initially offered three basic trades to investors: Price Return Swaps on the capital value return component of the NPI, Property Type Swaps on the total return by property type subindices (for all reported property types except hotels, as hotels comprise only less than 3% of the overall index) and Total Rate of Return Swaps for the NPI total return:
In a Price Return Swap, the capital value return component, published quarterly by NCREIF, is exchanged against a fixed spread. The fixed spread is used to balance demand on both the long and short sides of the trade (see Chapter 8 on the property spread).
A Property Type Swap on the total return by property type subindices is a total rate of return swap transaction in which an investor takes a long position in one property type and a short position in a different property type, based on the respective property type subindices. Depending on the property type swap that is entered into, the investor will either pay or receive a fixed spread to enter into this swap. The fixed spread will be determined by supply and demand in the market, and therefore could be positive, negative or zero.
In a Total Rate of Return Swap for the NPI total return the quarterly total return published by NCREIF is exchanged against a three-month LIBOR plus or minus a spread. The spread is used to balance demand on both the long and short sides of the trade.
All trades are notional based. This means that they are unfunded and the only cash needed upfront to enter the trades are margin requirements necessary to manage counterparty risk evaluated on a counterparty-by-counterparty basis. The trades settle quarterly and have a maturity of two to three years. In April 2007, the property company CBRE claimed that the first trade on a US subindex had been closed.
