Performing a mortgage valuation
The introduction of the commercial property derivatives market in the UK has raised some issues related to the valuation process of appraisers (according to the Royal Institution of Chartered Surveyors (RICS)). A sufficiently liquid market of commercial property derivatives would offer useful information about how the market expects property values to evolve. Appraisers could take this information into account when performing a valuation. However, appraisers may pay little attention to derivatives prices in the early stages of the market development.
When performing a mortgage valuation, appraisers prefer using comparable evidence. However, this approach has a number of shortcomings. First of all, it will always be retrospective by definition. Further, the illiquid nature of the physical commercial property market means that transactions are only rarely observed. Moreover, comparable deals may include covenants, incentives and lease clauses that are undisclosed but clearly price relevant and thus distort the comparability.
A forward price curve implied from derivatives could facilitate valuations and increase valuation accuracy by providing market forecasts for rents, yields and capital values on a daily basis. Such forecasts could be incorporated into the valuation process and would provide a timelier indicator than retrospective transaction data. Some appraisers already use derivative prices on the IPD All Property Index and its subsector indices as a starting point for the valuation process. Note that the valuations in turn are used to calculate the IPD indices. In effect, if appraisers follow more closely the forward curve of property prices, the index could follow the prices of the derivatives on them.
The impact of payday loans market
There is mixed evidence on the impact of a derivatives market on its underlying asset market. Some studies have found a reduction in volatility after the introduction of derivatives while others conclude that volatility was not affected or even increased.
The general reasoning for an increase in payday loans volatility states that derivatives attract speculators who may destabilize the base market and create bubbles, and that the closing out of hedging positions shortly before expiration creates additional price variation. On the other hand, a decrease of volatility could result as derivatives make a market more complete, reduce transaction costs and enhance information flows. Also, the transfer of speculative activity from the base market to the derivative market may dampen volatility.
Others suggests that derivatives improve the efficiency of incomplete markets by expanding the opportunity set faced by investors. This in turn should reduce the volatility of the underlying asset. Research show that option listings have beneficial effects and improve the market quality and liquidity of the underlying stocks. They analyzed the impact of derivatives on their underlying assets for 174 stocks that had an option listed on either the American Stock Exchange (Amex), the Chicago Board Options Exchange (CBOE), the New York Stock Exchange (NYSE), the Pacific Stock Exchange (PSE) or the Philadelphia Stock Exchange (PHLX) from 1983 to 1989. In particular, they observed a decrease in the bid-offer spreads and increases in quoted depth, trading volume, trading frequency and transaction size after the introduction of derivatives. In summary, the listing of options resulted in reduced transaction costs for the underlying stocks. Further, they found that information asymmetries decreased and pricing efficiency increased.
Get quick access to the property market with a loan
The British commercial property market is estimated to be about GB£ 600 billion. Pension funds, property companies and other professional investors own about half of this amount according to the Investment Property Forum (IPF) the parent company of PDIG. On the buy-side, a diverse range of institutions, investment banks and individuals exists. Either they are unable to get quick access to the property market or want to rebalance an existing property portfolio. On the sell-side, there are large property funds that worry about a market downturn and want to reallocate a property investment to bonds or stocks. In other words, sales involve larger volume trades and buys smaller ones.
In 2006, the buy-side was easier to see and to find than the sell-side. Investors were keen to take exposure to the underlying property index, while few investors with physical property exposure were willing to sell. In 2007, the situation has changed. Many investors such as large insurance companies are now concerned about their property investment and willing to hedge, while it is no longer clear who wants to take on the exposure.
For professional real estate investors, derivatives on the IPD All Property Index are a relatively crude tool since these investors often want to express a view on more finely differentiated subsectors, such as retail warehouses or offices in central London. Sector swaps started to bring the market closer to the needs of fund managers. Disaggregation could further play an important role in the property swap market, since the All Property side could feed off growth in the sector trades.
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.
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.
