Increasing volatility of credit

Derivatives reflect the market’s sentiment and expectation quickly in their prices. Improved understanding and transparency could foster the acceptance of real estate as an asset class. Further, derivative markets should provide accurate signals for an optimal allocation of capital and risk.

Higher attractiveness and better risk management possibilities due to property derivatives could drive property prices generally upward. In other words, the risk premium and accordingly the cost of capital shrinks, since risk can better be measured and managed. However, this will only occur when there is enough liquidity and risk management opportunities. The investment bank Merrill Lynch estimates that this scenario can begin to happen if derivative volumes traded reach at least the transaction value of direct property. The bank estimates the critical size in the UK to be GB £50 billion turnover per year for the commercial sector. With the rapid growth of the UK property derivatives market, such a feedback effect could soon be seen to start.

Another feedback effect concerns activity. Experts say that the introduction of a derivatives market potentially reduces trading volume in the spot market, since the transfer of risk and return through derivatives make physical transaction at least partly obsolete. However, evidence is mixed. Other studies show that the existence of derivatives have actually improved activity in the related spot market.

However, there is some concern that a successful derivatives market will lead to fewer transactions in the underlying property market, reducing the base market’s liquidity and increasing credit volatility. This may have a significant impact on the underlying indices used to measure property returns, particularly the capital growth indices, which rely on valuations based on transactional evidence. Derivative advocates argue that there will always be demand for physical property from investors who believe they can beat the market through picking individual properties and actively managing them.