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.
The credit and tax bindweed on the growth
In 2004, the authorities loosened the legal and tax bindweed on the growth of a wider derivatives market. One of the earliest derivatives swap was arranged between Deutsche Bank and Eurohypo in 2005, and brought together a buyer and a seller of UK property risk. The seller exchanged a total property return (based on the IPD Index) for a LIBOR-based return paid by the buyer based on a notional principle. Prudential, the UK life assurer, and British Land also agreed on a commercial property swap at about the same time.
The formal launch of the Property Derivatives Interest Group (PDIG) on 16 September 2005 has set the crucial signal for the property market in the UK, which may serve as a role model for property derivatives trading elsewhere. However, the UK is somewhat fortunate because the available indices that are run by IPD are mature and widely accepted as accurate. That is not (yet) the case in most other countries.
In 2006, the market could build on the growth of the previous year and attracted further investment banks. Several banks started to quote option prices on IPD’s main index. Further, it was hoped that the arrival of sectoral transactions would deliver a further boost to the market. However, after a few trades on sector and even subsector indices in 2006, there were no more such deals in the first half of 2007. In essence, it remained a simple swap and forward market on the All Property Index with a few option trades, before trading volume soared in the wake of the US subprime mortgage crisis. The uncertainty introduced by the crisis attracted a number of new participants in the property derivatives market.
The Credit Property Total Return Swap
By December 2007, property derivatives deals have been made public in Australia, France, Germany, Hong Kong, Italy, Japan, Switzerland, the UK and the US. Deals were referenced to both commercial and residential properties. Derivatives that reflect commercial real estate are typically tied to appraisal-based indices while derivatives that reflect owner-occupied residential housing usually use transaction-based indices as the underlying instrument (see property indices).
Most contracts are still executed as matched bargain trades between a buyer and a seller, with pricing determined through negotiations between them. As the market becomes more liquid, standardized contracts will become available directly from intermediaries. They will price the contracts and assume the risk of finding a suitable counterparty.
Several derivative structures have been developed and traded. So far, the bulk of trades has been structured as over-the-counter (OTC) swap contracts. In addition, a few derivatives are listed and traded on public exchanges. Most market participants are aiming to create derivatives that replicate the familiar characteristics of direct property investment, i.e. quarterly rental income and annual capital growth. As the market expands, the variety of structures increases. Derivative markets have a particular order of development and it is not unusual for options to develop after futures and swaps, because the option writers require these instruments to be liquid in order to hedge their positions.
The Property Total Return Swap (PTRS) is the most popular format and, in principle, swaps a fixed or floating interest payment for an amount calculated with reference to total returns on the property index, which consists of both rental income and capital gains (see swap transactions). The swap structure is quite simple and the variations usually only involve the choice of the index (country, sector and rental, and/or capital growth index), the tenor and the payment conventions.
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