(I WROTE THIS in response to an email about Property Derivatives):

I have written the Options chapter in a book on Derivatives. And I was once head of Commodity Derivatives at a large global bank.

PROBLEMS TO SOLVE,
to make a Property Derivatives Market viable
==============

We looked at Property Derivatives as a possible line of business. We identified two main problems:

+ "Basis Risk" : (Definition: the difference in price movements, between the Property index exployed in the derivative, and the specific Property valuey ou are looking to mimick.) The index used for settlement of the derivative must be meaningful for the transactions that you are trying to hedge. To put it another way, can I really hedge a 3BR House in Hammersmith, with a derivative linked to the Halifax Greater London index? The index employed, must also be what it is meant to be, else it is too risky. For example, there are problems with the method of calaculating the Halifax index, which may be obvious to you. In my opinion, it has a built-in bullish bias, and is tooi narrow. An additional issue is this: does a specific property in one location, relate closely enough to a index. You need a broad index to create interest from many parties, but if it is too broad, then the "basis risk" in relation to what you are trying to hedge will be huge,

+ Need for a two-sided market : Every trade must have a buyer and a seller. There are loads of people who will want to SELL a property derivative when the market is sliding. Because there are trillions of pounds value of property to hedge, there will always be someone who wants to sell. But who will BUY the derivative in a falling market? The best way around this problem is to issue property related bonds, with positive and negative linkages to a popular index. Then when the market is sliding, there may be some short covering to cushion a sharp fall.

The small number of Property hedges that exist are imperfect. If those offering them cannot manage their positions, they may suddenly shut down. IG INDEX stopped allowing two-way bets on its property index last year. I had a nice profit on some open short trades, and so I got caught by that. So the bugs are far from worked out, even now

= = =

Note:
For those of you who do not know what a "short" is, I will explain.
When you borrow a stock, and sell it, you gain if the stock falls, because you can buy it back more cheaply. But you are exposed to the risk that the stock (or index) will rise instead. If it rises, you will have to buy it back at a higher price. This can expose you to theoretical unlimited losses, if the stock goes to infinity.

In practice, I go "short" by purchasing "puts". A put is an option which is the opposite to a call.
With a put, you win on the downside, when the price falls. With a call, you win on the upside, when the price rises. To get this payoff, you pay an upfront sum called an option "premium". Your risk is limited to the premium. So for example, you might pay 100 points for a Dec. Put on FTSE struck at 5400. If FTSE rises, and clsoes above 5400, you lsoe the whole premium. If it falls to 5200, you would collect 200 points.
The cost of this insurance, depends upon the volatility that option sellers expect

= = =

(I also had this exchange by email):

"You need LOTS of indices as you say. Residential, Commercial,
office, retail, luxury homes etc etc, covering West London, East
London, London, South East, England, UK etc etc). We need an
independent organisation to take control of checking the methodology of
different indices and combining them and splitting them to offer
meaningful hedges"

NO. You need ONE index that works, in order to build liquidity.
Once the liquidity is big enough, and it is a demonstrated success, a second and a third hedging index can be added, and the appropriate buyers and sellers can then be sought.

If an exchange or a bank launched multiple indices straight away if would fragment the initial interest, and they may all die for lack of trading appetite, or because spreads are too wide. My guess is that a Greater London residential index would be the best start. But the Halifax index is too flawed for a number of reasons (mainly it gets pushed up when FTBers and BTLers slow their mortgage requests on cheaper places.)

Bubb,

FWIW I think long dated gilts provide some hedge against the property market at the moment, albeit a very imperfect one.

What do you think?

I am the guilty party who emailed Dr Bubb.

My basic issue here is that I am considering writing a dissertation on Property Derivatives as part of a Masters. I want to understand derivatives inside out (and then property derivatives), and ideally (long term) I want to gain money / employability by overcoming some of the problems preventing the market from burgeoning.

I am more concerned with commercial property at this stage - there is a tiny band of bankers / property professionals trying to push commercial property derivatives and a decent index to base them on (IPD UK All Property Index). To my knowledge, residential derivatives basically come down to spread betting on indices (who still does this)?

If anyone has any questions I can try to help. In the meantime I can see myself asking Dr Bubb some questions and bouncing ideas off him and others

FF

Hi FF,

thanks for posting here.
There is some history you may not know about.

Property Futures were launched some years ago by the London FOX exchange.
I was even invited to a lunch hosted by the head of FOX to try and convince my bank to use the market.
But it became a predictable failure, because they never created an institutional following for the contract.
And without the big institutional following, it was impossible to generate any genuine liquidity.

The FOX got fired for sponsoring some artificial trading (mere crossing between related parties.)

The key starting point for success, should be thinking deeply about who is going to use the market,
and when. A lot of potential users will only be interested in selling the Property Derivative when they
perceive the market is near the top. Who will be the buyers on the other side of the trade?
And how do you create liquidity between cyclical peaks?
= = =

Lessons from the FOX Residential Property Futures and Mortgage Interest Rate Futures Market

Kanak Patel - University of Cambridge Abstract On May
Source Fannie Mae Foundation

On May 9, 1991, the London Futures and Options Exchange (FOX) introduced four property futures contracts to make possible the development of facilities for hedging, arbitrage, and price discovery in the commercial and residential markets. Two contracts were based on the Nationwide Anglia Building Society house price (NAHP) index and the FOX mortgage interest rate (MIR) index. Trading in the contracts was suspended in October 1991, partly because they failed to gain economically viable trading volume. To identify reasons for the failure, this article analyzes the opportunities and difficulties of using such contracts. The main findings are that owing to lag dependence in the NAHP index, the futures contract did not provide the economic benefit from hedging market risk that stock index contracts provide and that potential arbitrageurs and speculators were deterred from using the MIR index contract because of high transaction costs and long time lags involved in processing new mortgage loans.

@: http://www.knowledgeplex.org/showdoc.html?id=2534

= = =

Another article: http://www.financialsense.com/fsu/editoria.../2005/0929.html

Deleted.

PROPERTY DERIVATIVES: AN OVERVIEW
by David Shvartsman ... September 29, 2005

A relatively new innovation has come to the world of real estate finance, one that could broaden acceptance for real estate as an asset class. Property derivatives are gaining traction in Europe, making it easier for pension funds and investors to take positions in the property markets.

A derivative is a financial instrument that is valued in relation to an underlying asset or price index. Derivative instruments can be used to hedge risk in portfolios and business operations. When used as a trading instrument, they provide exposure to the price movements of an underlying market. Property derivatives can be traded quickly and easily, in contrast to physical property transactions with the involved processes and associated costs. A recent survey by the Property Derivatives Interest Group (PDIG) suggests that there is considerable demand for such products in the financial community, and groups controlling nearly $81 billion of commercial property have already been cleared to trade in this new market. [1]

Some observers have pointed out that property is one of the last major asset classes in the Western markets without a liquid derivatives market behind it. The UK may have the advantage in leading the market forward due to the availability of relevant property indices, such as the Investment Property Databank (IPD) UK property index (IPD is a private firm that collects information on property market performance across a variety of countries and is considered to be the leading benchmark. http://www.ipdindex.co.uk/results/indices/indices.asp).

...MORE: http://www.financialsense.com/fsu/editoria.../2005/0929.html

Dr Bubb

The Fox stuff I did read about earlier today (and now I can't find where!) I need to read what you have linked to as well, but I can safely say it's a lot longer than what I read earlier.

As for the financial sense article... that was a pretty decent concise summmary of about 15 articles I read this afternoon!!!!

Plenty of reading for me to do and I'll be posting again when I have digested some of it!

FF

The issues –

(1) How to get critical mass/ liquidity?
(2) Do we need standard contracts and how best to bring them in (currently deals are related to commercial property and brokered/ negotiated individually)
(3) Overcoming risk, notably time basis risk and cross-hedge basis risk.
(4) The conflict between (1) and (3) – the more you try to
overcome cross hedge basis risk the more likely you are to have liquidity problems on individual products.
(5) Benefits of price information that a PD market would provide

Possible questions –

(1) What lessons can be learnt from FOX attempts at property derivatives in 1991?
(2) To what extent is basis risk really an issue? (Property is very very illiquid and tends to change price quite slowly. If I could only ensure 3/4s of the value of my house against fire I still would – I’d rather buy a smaller scruffier place if mine burnt down than be left with nothing. Does the fact basis risk exists really put fund managers / developers off, or is a reasonable hedge better than no hedge?)
(3) Are arbitrageurs vital to the efficiency and success of the PD market and what will it take to get them in?
(4) Is IPD data good enough? (Probably).
(5) What are the benefits of PDs – is it worth the effort?
(6) Given commercial PDs are starting to take off, how can we go about getting residential up to speed (especially given the different indices and issues regarding their trustworthiness)?

Any thoughts on which issues are most important to pursue? Any questions that I have ommitted to ask?

Also, Dr Bubb, I’d love you to explain something to me.

From the ‘lessons from futures market’ article on page 17 out of 18, paragraph starting ‘The failure of the NAHP index’ it says –

"First, given the restrictions on short-selling a portfolio of houses, the standard futures and cash market arbitrage relationship would not be useful in pricing the NAHP index contract. Therefore, at any given point, market participants would have no mechanism for ensuring what would be ‘fair’’ value of an NAHP contract"

Is that just saying, it’s hard to price PDs as market information is only what you get from people buying long actual property (as well as the info you get from the futures market itself). How much of an issue is that?

FF

Father Fred

The following two links might also interest you:


http://www.cme.com/about/press/cn/04-188Ho...Index10813.html

http://www.londonstockexchange.com/NR/rdon...perty_Aug04.pdf

FF,
Good comments, and here' s key part:
"the more you try to overcome cross hedge basis risk the more likely you are to have liquidity problems on individual products."

EXACTLY.
If you had a different index for each Postal Code, or each street, it would be great. But there would be zero liquidity, so you need to capture a big enough population of properties that there is regular trading, and wide interest in the index. But not so wide that the index does not effectively reflect what is happening to the value of an individual property.

Thus, a UK-wide index is probably not going to provide a good hedge for a London property, since London tends to lead by a year or so, and may show biogger swings.



= = =

"First, given the restrictions on short-selling a portfolio of houses, the standard futures and cash market arbitrage relationship would not be useful in pricing the NAHP index contract. Therefore, at any given point, market participants would have no mechanism for ensuring what would be ‘fair’’ value of an NAHP contract"

I am not fully sure what this means...
But taking a stab at it: There is no way to go short an individual property the way that you can short a stock. In stocks, it is easy to borrow some shares, and sell the shares short. How do you borrow a house? And once you have sold a specific house, someone else owns it, so you would have to buy back that house to cover the short. Houses are not fungible, the way that share certificates are.

Ohhh I am enjoying this discussion....

To start things off - I think Bubb basically got the meaning of this correct

"First, given the restrictions on short-selling a portfolio of houses, the standard futures and cash market arbitrage relationship would not be useful in pricing the NAHP index contract. Therefore, at any given point, market participants would have no mechanism for ensuring what would be ‘fair’’ value of an NAHP contract"

----

But I would like to expound a little further if I may....

As Bubb already pointed out, the advantage of being able to short the underlying component of a derivative is that if you are making a market you can buy/sell the underlying to completely hedge out your exposure. This effectively removes your reliance on market participants for liquidity.

However, this nice cosy market making relationship is not the whole equation of a succesful derivative market, since there's also basis risk. When your market becomes free flowing and has many buyers and sellers it will allow the buying/selling in your derivative market to drive the price wildly away from the underlying. Except for speculators, who's gonna want to use your derivative market if it comes with a huge basis risk.

And the natural solution to this are the market arbitrageurs (spelling!) who will use the rules of arbitrage to price the market accurately for you, remove basis risk, and increase liquidity. If they see your derivate is under priced according to the price for which they can obtain and hold the underlying then they will sell your derivate, buy the underlying and let it go to expiry with a guarenteed gain. Similarly they will buy your derivative and borrow and sell the underlying to make a profit if they think your derivative is underpriced. People will speculate in this way even if there isn't a true arbitrage, and all your pricing and liquidity woes will be gone. You don't even need a proper underlying in this case since if the property index veered away from what was actually happening in the market - the arbitrageurs would fix the pricing for you so it suited their needs.

This arbitrage relationship is also essential to help keep derivative and underlying markets in line. It is what communicates heavy selling/buying of the derivative to the real market (and vice-versa). As the one market vears away from the other, they are both snapped back into balance. This will happen, even if it isn't exactly clear what the real price of your underlying is, since lots of people will use their individual observations to price it for you.

As the quote above says; this doesn't work in housing markets, because people can only arbitrage your market up, and not down (I hear ol' Gordon laughing in the background!). Even with an artificial bond based underlying (as Bubb suggested), it wouldn't communicate the effects to anything except the underlying bond which would then just wind up being wildly mis-priced with respect to it's NAV. Basically, and to be effective, the housing derivative market must result in selling/buying of houses to the market at large and an adjustment in the underlying prices.

Of course, you could force all property owners into advanced financial planning classes and let STR's do this for you; but STR is a slow illiquid process whilst I suspect the market in housing derivatives would need to be fast and liquid. The same would be true of holding a huge property portfolio and hedging your derivatives against that. Subsequently; I think the big thing is the time basis risk of marrying a high liquidity market with a slow liquidity underlying. Even if you have some underlying exposure your just gonna get swamped as the high liquidity market overrides your slow liquidity underlying (I suspect this is what happened to IG Index). It makes the market unattractive to all - hedgers, arbitrageurs or speculators.

Now ... if you were to link it to a portfolio of mortgages, and heavy market selling resulted in you offseting your derivate risk by raising mortgage rates, which then resulted in increasing foreclosure ... that might work! What I hear you say, it's imoral! I don't see the problem - it's no less immoral than encouraging housing bubbles in the first place MUHAHAHAHA

T2RIR

There was no need to delete that post... no offence taken!!!!

Bubb / Footsie / Kinky etc

So much going through my head...

Firstly, commercial property vs residential. For the moment I am going to dismiss residential. The course I am doing is primarily concerned with commercial property, and the current efforts of the property industry with relation to PDs are related to commercial. The property investment industry primarily invests in commercial and the big property developments are to a fair extent commercial as well (though there are obvious big resi projects).

I was reading half the weekend and I didn't realise my copy of Estates Gazette from Saturday 8th October was sat there with a 6 page article and 1 page editorial relating to property derivatives!!!! In short, the PDIG (property derivatives interest group, part of the Investment Property Forum, which in turn is related to the IPD, Investment Property Databank) has started a game using monopoly money for big players in the asset management/ investment banking / property industries. They traded for 4 hours last Thursday and will trade every 2 months or so for the next six months. I believe the aim is to get people confident in the market so they are more likely to trade in the real world. I do not know the format of the market platform or how possible it would be to transfer it to the real world - the article doesn't really go into that. I believe the market infrastructure is undeveloped as yet. Rupert Clark, Head of Property at Hermes, is largely responsible. In addition I have emailed one of the research blokes at the IPF and got some info (not as much as I'd like but a start).

So far it seems to have been OK. Similar viewpoints did not appear to be a problem as pricing indicated varying views of value. (This could be due to people not taking it too seriously, though they are under instruction to keep trading to what they would be prepared to do in the real world). Apart from that the article is fairly vague. I think they are trading the IPD UK All Property Index which is basically the Index of Investment Grade UK Commercial Property. They are also trading the sub-indices that relate to specific sectors - Industrial, Office, Retail, thus enabling people to swap exposure in one sub-sector for exposure to another. It also appears from surveys of participants that people plan to hold derivatives to expiry (3 or 4 years usually) rather than actively trade them.

The people who will benefit from the market are those who are just looking to hedge exposure to the commercial property market generally and between sectors. People who wish to hedge specific properties will have to find willing counterparties 'by hand'.

My understanding of hedge funds is they tend to invest in derivatives in -

(1) Things they invest in directly
(2) Things they understand a lot about

Both of these things point to the fact that they are unlikely to invest a lot in property derivatives as described above. Which points to a lack of liquidity. The only consolation is that players in the property industry do not appear to be desperate for liquidity (as they, generally speaking, are happy to hold PDs for several years to maturity - ie are not looking to trade). The problem of liquidity will perhaps only be a particular issue to the industry in that it will minimise the positive effects that liquity has on accurate and fair pricing... it is less likely to put off participants who are scared by the likely difficulty in selling on that exposure before maturity.

This points to the fact that the market is unlikely to become very liquid and standardised. It is more likely to develop as a less formal, ad hoc market where people basically take out 3 or 4 year insurance policies 'off the shelf' or approach brokers looking for more specific products to their needs and get a policy 'bespoke'. I still think it will develop but I am struggling to see it taking off in a big way (though this might happen if the property industry develops the market enough to tempt hedge funds to try to get a piece of the action.)

I am uncertain that basis risk is a massive issue as the likely participants are looking to hedge in a general way over a number of years (eg gain exposure in a market they feel under-exposed in), rather than looking to hedge something perfectly over a very precise time.

Question - what is the difference between strategic and tactical trading?

Back to residential. Another matter entirely as I said... and one which I will have to consider, but probably not the focus of my dissertation. Laters on this one!

FF

Father Fred

I'm glad you took it in the spirit it was meant. All the best.

I'm interested to know if anybody here is short the house market using IG Index or other?

From what I have researched, the spread is wide, and IG is the only viable way to hedge the market.

Of coures the other option is to sell out and suffer expensive transaction costs.

ANOTHER WAY in to the Property Derivatives business is through betting...

Property investor website Landlordtrader.co.uk has partnered with gambling site Berfair.com to create the housing price market.

Dan Haysom, business development manager at Landlordtrader.co.uk, said he believes the service will appeal to property investors as well as people who are yet to dip their toes in the buy-to-let market perhaps due to financial constraints or those that don't have the stomach for such risks.

“It seems a natural progression for a betting exchange to offer their clients the opportunity to bet on a market which, until now, has required an enormous stake.

“Now, in principle, everybody can have a piece of the action for as little as £2,” he said.

http://www.landlordtrader.co.uk
http://www.betfair.com

= = =

I HAVE STARTED threads,
on HPC : http://www.housepricecrash.co.uk/forum/ind...0&gopid=221934&
on S-Pig: http://www.singingpig.co.uk/discussion/for...=41&m=83744&p=1

And have asked these questions:

What does the market structure look like?
+ What index is used for settlement?
+ What is the size of the bid/offer spread?
+ How liquid is it?
+ Whose credit risk are you taking?

FF,
Your:
"The only consolation is that players in the property industry do not appear to be desperate for liquidity (as they, generally speaking, are happy to hold PDs for several years to maturity - ie are not looking to trade). The problem of liquidity will perhaps only be a particular issue to the industry in that it will minimise the positive effects that liquity has on accurate and fair pricing... it is less likely to put off participants who are scared by the likely difficulty in selling on that exposure before maturity.

This points to the fact that the market is unlikely to become very liquid and standardised. It is more likely to develop as a less formal, ad hoc market where people basically take out 3 or 4 year insurance policies 'off the shelf' or approach brokers looking for more specific products to their needs and get a policy 'bespoke'"

It would be a shame if Prop-Derivs got stuck with orphan status.
They will never show their real power until they have become truly liquid.

You are on teh right track: Some core risk within the property market needs to become standardised for PD's to work. There are various ways to do that, at first they may seem somewhat artificial. But once the traders realise their advantages, then they will become useful to both longs and shorts. I want to give an example of hopw this would work, but need to think a little about how to apply the formula to property, and how to explain it in a simple way. So I will return later with a better description of one technique.

= = =

SECURITISING PROPERTY:

1/the "property Bond solution"
(more later)

Hello again all, and especially Dr Bubb.

Having been busy with all sorts of things for the last few months, I am soon to get back on track and try to get my dissertation proposal started / completed. (My posts a few months back were an indication of starting early before getting sidetracked by the way, most of my peers are still trying to work out a topic area. I don't want anyone to think I've jjust left it to the last minute!)

Anyway, any thoughts are gratefully welcome, and I'll be posting the odd question and summary of my thoughts over the next month or so as and when I really get stuck in to it.

FF

Well its not going to matter what you thinking of doing the end result for the housing will be the same as for the worlds financial system (collapse). in the search column on google type in Derivatives monster $250 trillion january 2006.

"Question - what is the difference between strategic and tactical trading?"

Timeframe, i suppose.

Strategic trades may stay on for months or years.
Tactical ones, for days or weeks.

The beauty of a Property derivatives market is that it would give the tactical traders a chance to play.
It is hard for a tactical trader to get involved in physical property since the in-and-out transaction costs,
are so terribly high

Any comments on the following as a starting point for a dissertation proposal?


The future of property derivatives – how they can benefit the investment industry and what issues need to be overcome to maximize those benefits.

Introductory Issues

Commercial property only (Why? Brief comments on residential, spread betting etc)
Strengths and weaknesses of IPD Indices

What are the types of organization that should be interested in PDs? [Is it reasonable to break them into these 4 main groups?]

Property Companies
Institutional Investors (Insurance companies, pension funds etc)
Intermediaries (Investment Banks)
Hedge Funds

What are the benefits of an expansion in the use of PDs?

(1) Any investment vehicle can make an investor money!
(2) Possibility of increasing or decreasing property exposure without
associated transaction costs. This is linked to the possibility that property investors will be able to reduce their annual costs (ie less management charges, consultancy fees, SDLT etc)
(3) Benefits of price information that a PD market would provide.

The issues to be overcome if PDs are to take off –

(1) How to get critical mass/ liquidity?
(2) What form should standard contracts take?
(3) Do we need standard contracts and if so what is the best way of bringing them in? (Currently deals are commercial and brokered/ negotiated individually)
(4) Overcoming risk, notably time basis risk and cross-hedge basis risk.
(5) The conflict between (1) and (3) – the more you try to overcome cross hedge basis risk the more likely you are to have liquidity problems on individual products.
(6) Are arbitrageurs vital to the efficiency and success of the PD market and what will it take to get them in?

Hypotheses – [Which of these are reasonable, which not, how many should I have in your opinion?]

(1) The issues are… [as above]

(2) For liquidity the market needs the liquidity that arbitrageurs (hedge funds) provide.

(3) Hedge funds will not enter the market in the foreseeable future (as they tend to invest in derivatives when they hold the underlying asset and they don’t tend to hold property)…

(4) … therefore we are unlikely to see anything more than an over-the-counter market where investment banks broker deals with each other, investors and property companies

(4) The benefits of property derivatives are potentially huge, but will not be maximized due to the absence of arbitrageurs.

(5) The future will involve a greater concentration of underlying assets amongst the property companies who use specialist knowledge to outperform the indices. This will leave investment companies to concentrate on derivatives, happy to match the market with greatly reduced transaction costs.

(6) Prices of actual property will be more realistic as there will be fewer companies actually fighting over the properties themselves. This will lead to a reduction in the likelihood of boom and bust in the commercial property market.


Possible Sources of information

I propose to send questionnaires to a number of industry players from the 4 main organization types that I have identified, and hopefully interview a number of them for a more detailed perspective.

How much do you know about PDs?
Would you consider trading PDs?
What would it take you to get involved?

Type of PD

CFDs. Are these generally at zero consideration and very much like spread betting? ie strike is 10%, I believe the market will underperform, you believe it will overperfom, we agree a price per % and a timeframe and settle up at the end? (Oversimplification I know, there is normally a spread as well)

What seems to be most likely to take off are IPD All Property Total Return Swaps, where one counterparty pays the IPD APTR and the counterparty pays LIBOR plus x, both on a given quantity. [though swaps based on Libor and subsectors, or swapping between subsectors also seems likely to take off]

Pricing.

Can I have some thoughts please?

What should x be and why? Currently the deals done and "games" played indicate a x being around 200 bps. This indicates bulls believe commercial property will exceed 6.5% total return, whereas bears believe less. Given last years APTR was 17% or so that indicates a huge feeling that those returns are not possible again next year. But many are predicting returns in excess of 10% plus so why are they priced so low (remember APTR includes rental return as well as capital growth therefore predicting a 10% return where yields are 5-6% is only predicting a capital rise of a couple of percentage points above inflation, so you could be fairly bearish and still predict 10% returns).

What am I missing? Any comments on pricing APTR swaps?

Another question on pricing.

Let us assume (for simplicity) LIBOR is 5% and yield is 5%, so with no spread or profit if you believe capital growth willl be 0% then a swap between all property total return (income plus capital growth remember) and LIBOR would leave both counterparties even.

Let's say I believe CG will be -10%, giving an APTR of -5% (-10% + 5%). Rationally I will be happy to receive LIBOR -5% in return for APTR as that will put me 5% up if my predictions of negative CG are correct.

Sorry to be so ignorant of derivatives, but is that how swaps would usually work if the market was fairly bearish about the return on the underlying asset?

Pricing.

Can I have some thoughts please?

What should x be and why? Currently the deals done and "games" played indicate a x being around 200 bps. This indicates bulls believe commercial property will exceed 6.5% total return, whereas bears believe less. Given last years APTR was 17% or so that indicates a huge feeling that those returns are not possible again next year
= =

Pricing?: DIFFICULT to estimate...

Depends on the index, I suppose.

Personally, I think that Total return swaps will be difficult to market. They will appeal to Funds and Pension managers, which is potentially a HUGE market. But these guys are highly conservative, and are not normally the pioneers in a new market.

I think that something that can be embedded in Bonds would appeal. For example, a bind which pays an yield related to property returns, and has a redemption value that is linked to an index may appeal, since it would represent a synthetic property.

In terms of returns, keep in mind that property returns, and particularly total returns, arr going to be more volatile than bond yields.

1/
Here is a ten year history of returns on the US ten year Bond (TNX):



2/
Ten year history of Gilt yields



You can see that both of these have been in fairly tight ranges for many years.

I dont have the figures, but I reckon that property yields have been higher than this, and total returns have been much higher. Falling interest rates, and increasing enthusiasm for property, have brought fat capital gains, boosting total returns.

NOW, here are two important points:

+ Total return swaps may be popular for fund managers, because they may expect them to continue to be higher than the now-moderate bond yields, but

+ Total returns on property can GO NEGATIVE, while you are never going to see negative interest rates on bonds. Albeit bonds can have negative returns when capital losses exceed the interest coupon

Total Return Swaps seem that they might become popular as they are a very simple and effective way of –

(1) Gaining exposure quickly and cheaply (compared to buying physical property which is likely to take 6 months and 7% in fees / stamp duty

(2) Reducing exposure when you feel the market might fall but you don’t want to sell your physical assets (cost, time, cost of rebying again at a different point in the cycle.)

(3) Reducing borrowing costs on physical property by being able to show banks that you are low risk because you are hedged in the derivative market.

I believe the thrust of my dissertation will be that we need funds managers / arbitrageurs / property companies AND intermediaries for a truly liquid market that maximises the benefits possible. So I’ll put your theory to the test regarding funds and pension managers!

What you are referring to are things like Barclays PIC (Property Index Certificates) which are Eurobonds and very much like you described (Dr Bubb: see email for more info). I take these to be quasi derivatives rather than true derivatives, and I would have thought you of all people would be advocating the real thing!! Why should PICs be more popular, not least because all you can do is buy exposure to the market (go long) rather than sell short (unless you are issuing the bonds in which case you are selling short if you are selling the bonds without having the long property or reverse position to counter it.) Surely the ability to go long OR short is the key thing, and PICs do not give you that? Or am I missing something?

If the index were to go negative would Barclays be seeking a payment from the bond–holder?

The thrust of my dissertation will be the likely success or failure of total return swaps and sector swaps.

It could be that a property owner expecting 10% capital falls would rationally wish to hold his property given the income return and the costs of selling. How do you price a swap if the market all thinks like that? Can swaps be priced at LIBOR – 5%? (ie I’m happy for you to pay me 0% per annum as I believe that will outperform my property portfolio, which I do not believe, given the costs involved, I should be selling despite my prediction of capital losses).

The COST SAVINGS on transactions is a big selling point:

Competitive costs: PICs provide investors with a cost competitive
option when compared with the various costs associated with the
purchase and sale of direct property investments, which are currently in
the region of 7.75%. This is primarily because there are none of the
administrative, due diligence and legal expenses associated with the
purchase of commercial property and because stamp duty is not payable
on issue or subsequent transfer of the PICs.
= =

BUT WHAT ARE the historical returns???

LAcking information on this, I am losing interest fast

http://www.ipdindex.co.uk/results/indices/...x_uk_annual.asp

go to "download" index in the top left.

thnx,

........Last 5 years vs. 2004 ........... : ........2004 on its own
.

there already is a Derivatives market in property (of a kind). its called the MBS market, or Mortgage Backed Securities. traded almost exclusivly OTC. don't know much about them as Exchanges are my 'thing'. MBSs are to iregular to have a listed Exchange traded derivative IMHO. despite it making much more sense than the frankly crazy Weather futures people were listed a few years ago.

Pricking the Bubble: Housing Futures as a Hedge Against Real Estate Volatility

Thursday, May 25, 2006; 2:00 p.m. (ET)

Retail and institutional investors can soon short San Diego and go long on Houston, or vice versa, after the inauguration of the Chicago Mercantile Exchange's housing futures index. In this discussion, the key intellectual author of this newly tradable asset class explains the market rationale for housing futures, and explores housing historics. He's joined by an economist at the Chicago Mercantile Exchange who makes the case for housing futures and explains how the index will work, and the Chicago exchange's intermediary broker who walks listeners through the nuts and bolts of trading housing futures.
= =

Listeners will learn:

+ Why the author of "Irrational Exuberance" thinks the end of the real estate boom is imminent and why he thinks housing futures can mitigate home owners' risks.
+ What housing historics may say about future real estate prices.
+ Features and design details of the index.
+ The mechanics of trading housing futures

@: http://ems.euromoney.com/ems/r.asp?cIndex=...dioconferences/

You can spread bet residential property derivatives at www.speadfair.com. This service is an open order book and so allows you to trade directly against other investors... far better than the IG service ever was!!

I have looked into the property derivatives market in some detail. The market is basically 'over the counter' only and only for big (exposure > £5) players. The other thing to notice is that the financial liability of each transaction is held be each counterparty. So the only people/ companies that can do anything in this market are the very big one with a AAA credit rating. This would probably explain why almost all the trades that have taken place so far are between the banks. Some big property companies (eg. British Land) have taken part, but so far this market is not serving a great deal of use for anyone.

I have been instrumental in creating the open order book spread bet market for residential house prices at www.spreadfair.com. This caters for smaller people that may want to hedge the exposure of their property portfolio, a new property development, or just their own home. Soon there will be markets added for residental property using the IPD index. Also an options market will be created so that participants can hedge their exposure to the downside, with a clearly defined and limited cost on the upside.

It will be interesting to see how this market evolves as it is in fact a web based futures market! Operating much like the markets provided by Liffe, but being more easily accessible to the average man on the street!

Hello DrBubb, Father Fred & other members,

I am also writing a thesis about property derivatives, more specific, I look at the possible applications of property derivatives ( PICs and Property TRS ) for fundmanagers and institional investors. I have read your discussion and I agree with the summary of market observer except his point about the statement that the only companies that can do transactions have to be AAA credit ratings. By a colleteral in the form of property, companies with a lower rating should be able to participate also in the PTRS market.

Does anyone has a comment on that?

I have another statement that I would like to discuss. When looked at the property magazines and press releases of companies in the field there is suggested that there are two separate markets; one for PIC and one for PTRS, in fact these markets are the same because the backend ( property sell side ) is structured as a PTRS with the PIC issuer who sells to property buyers. This means that there are not two markets with two volumes ( 1,4 billion and 1,9 billion ) but only one volume of 1,9 billion pounds of trades since 2005.

Does anyone have a comment on that?

As said I am doing a research about the possible applications of PTRS and PICs. If anyone is interested I would like to post some applications and I am curious if you see this as a real opportunity or just as a theoratical option with no feasibilty in “real live” due to other / better investment tools or regulatory problems.

I am also curious about the status of the research of father fred. If you are into a discussion about some topics I am interested. Propably we can share some insights.

I am looking forward to your reply,

Rick

Hi all,
it was a pleasure to follow the discussion. I will be very thankful if someone points out nice sites and document (maybe books) regarding property derivatives.

Thanks a lot.

I have a fundamental question: from what we have read observed so far, as of Today, do you think Property Derivatives are more or less liquid than actual "hard asset" investments? Appreciate any comment~ Thanks!!