Real-Estate Derivatives : From Econometrics to Financial Engineering

289 Pages·2017·3.1 MB·English

by  Radu S. Tunaru

OUPCORRECTEDPROOF–FINAL,27/2/2017,SPi
Real-Estate Derivatives
OUPCORRECTEDPROOF–FINAL,27/2/2017,SPi
OUPCORRECTEDPROOF–FINAL,27/2/2017,SPi
Real-Estate
Derivatives
From Econometrics to Financial
Engineering
Radu S. Tunaru
1
OUPCORRECTEDPROOF–FINAL,27/2/2017,SPi
3
GreatClarendonStreet,Oxford,OX26DP,
UnitedKingdom
OxfordUniversityPressisadepartmentoftheUniversityofOxford.
ItfurtherstheUniversity’sobjectiveofexcellenceinresearch,scholarship,
andeducationbypublishingworldwide.Oxfordisaregisteredtrademarkof
OxfordUniversityPressintheUKandincertainothercountries
©RaduS.Tunaru2017
Themoralrightsoftheauthorhavebeenasserted
FirstEditionpublishedin2017
Impression:1
Allrightsreserved.Nopartofthispublicationmaybereproduced,storedin
aretrievalsystem,ortransmitted,inanyformorbyanymeans,withoutthe
priorpermissioninwritingofOxfordUniversityPress,orasexpresslypermitted
bylaw,bylicenceorundertermsagreedwiththeappropriatereprographics
rightsorganization.Enquiriesconcerningreproductionoutsidethescopeofthe
aboveshouldbesenttotheRightsDepartment,OxfordUniversityPress,atthe
addressabove
Youmustnotcirculatethisworkinanyotherform
andyoumustimposethissameconditiononanyacquirer
PublishedintheUnitedStatesofAmericabyOxfordUniversityPress
198MadisonAvenue,NewYork,NY10016,UnitedStatesofAmerica
BritishLibraryCataloguinginPublicationData
Dataavailable
LibraryofCongressControlNumber:2016956900
ISBN 978–0–19–874292–0
Printedandboundby
CPIGroup(UK)Ltd,Croydon,CR04YY
LinkstothirdpartywebsitesareprovidedbyOxfordingoodfaithand
forinformationonly.Oxforddisclaimsanyresponsibilityforthematerials
containedinanythirdpartywebsitereferencedinthiswork.
OUPCORRECTEDPROOF–FINAL,27/2/2017,SPi
ThisbookisdedicatedtomywifeDiana,thankingherforher
longstandingsupportandremarkableinfinitekindnessinthe
faceofadversity.
OUPCORRECTEDPROOF–FINAL,27/2/2017,SPi
OUPCORRECTEDPROOF–FINAL,27/2/2017,SPi
PREFACE
Recentlyfinancialderivativeswereportrayedas“weaponsofmassdestruction”
byfamousinvestorslikeWarrenBuffett.Thiswasnotthatlongafterhetried
tobuyLongTermCapitalManagement(LTCM)onthecheap,unsuccessfully.
Should we really be worried about financial derivatives? First of all there is
evidencethattheywereusedasfarbackas8000B.C.bySumertraderstolock
incontractsintothefutureandtakeadvantageofseasonality.Thus,financial
derivativeshavebeenaroundforalongtimeandsofar,therehasnotbeena
massdestruction.Theycouldbeusedthoughtodestabilizefinancialsystems
and in the last three decades almost all financial disasters involved financial
derivatives.ButthisdoesnotmakeWarrenBuffettright.Antibioticscanalso
haveadetrimentaleffectonmillionsofpeopleiftheyareusedwrongly.Still,
I do not believe that we should eliminate antibiotics and likewise, I do not
believethatweshouldstopusingderivatives.
Whatfamouspeopleperhapsshouldargueforisnottousefinancialderiva-
tiveswheretheyarenotneeded.Giventhatapartfromforwards/futuresand
swapsthemajorityoffinancialderivativeshavenonlinearpayoffs,theycanbe
used to leverage the positions and take high risk through financial markets.
By the time the financial markets settle down large amounts of money can
moveintothehandsofspeculators.
Arederivativesneededbysociety?Themostdevelopedeconomiesaredom-
inated by real-estate which represents a very large part of total wealth. The
crashingofpropertymarketsaroundtheworldhasledtoperiodsofrecession
and instability. It seems paradoxical that exactly where they are needed the
most,inreal-estate,derivativesareininfancy.Hopefullythisbookwillmoti-
vatethoseinkeypositionstoactimmediatelyandhelptheexpansionofreal-
estatederivatives.Thereisagenerallackofknowledgeofreal-estatederivatives
and this book is aiming at offering academics, investors, regulators, hedge-
fund managers, risk managers, model validators, postgraduate and research
studentsinFinanceandReal-Estate,avaluablesourceofinformationthatcan
servethemasaguideintheiractivities.
Itisassumedthatthereaderhasbasicknowledgeoffinancialmarkets,finan-
cial modelling, financial economics and statistics. The analysis presented in
thisbookcanbecarriedoutwithExcelandMatlabandmanydatasetsusedin
thisbookareinthepublicdomain.
WhileworkingontheRMBSdeskinLondonatMerrillLynchIcameacross
a very interesting small portfolio in the aftermath of the subprime crisis. It
was a set of property forwards on a real-estate index representative for the
OUPCORRECTEDPROOF–FINAL,27/2/2017,SPi
viii PREFACE
UKmarket.GiventhesizeoftheresidentialmortgagebackedsecuritiesIhave
thoughtthattheremust beawiderangeofderivativescoveringhouseprices
offeredbythebanks.Thisprovedtobewrongandtherestartedmyjourneyin
thisimportantareaoffinance.
At the time I have finished writing up this book the UK voted to leave in
the Brexit referendum. There will be no doubt a lot of uncertainty over the
yearstocomebutIhopethattheevolutionofreal-estatederivativeswillnotbe
hinderedbythenewpoliticalclimate.Thereisaneedforreal-estatederivatives
inordertostifleoutspeculationonpropertymarketsthataredetrimentaltous
all.Thebigquestionishowtokick-startthismarketwhenthepropertymarkets
stayforlongtimeonabullrunreachingbubblestates.Thepropertyowners
wouldliketohedgethevalueoftheirpropertiesandtheywouldbenaturally
shortonthesepropertyderivatives.Thebanksshouldbelongpropertyprice
risk since it is the only way they can be truly fully diversified. The recent
stress exercises introduced by central banks and supervisory authorities will
asktopbankstoshowtheeffectsofamarketdownturninreal-estateontheir
portfolios.Propertyderivativeswouldhelpbanksmanagethisenterpriserisk
managementexercise.Thisseemstometobethewayforward.
Organization of the Book
This book can be used for a graduate class on real-estate finance and as an
electivemodule onMBAandpostgraduateresearchprogrammes in finance.
Ultimately, the specialists working in investment area with exposure to real-
estatepriceriskneedtobeawareofseveralfacetsofthistypeofrisk,whichare
hopefullycapturedinthechaptersofthisbook.
Chapter 2 presents the main real-estate indices used worldwide for
investmentpurposesandonwhichderivativescontractsareverylikelytobe
issued.Forinvestorsinfinancialmarkets,mortgagesarethenaturalcarrierof
real-estaterisk.Thus,anintroductiontothisassetclassisgiveninChapter3.
Thedistributionofriskresultingfromholdingmortgageloanshasbeendone
inrecentyearsthroughthechannelsofsecuritization.Theinvolvementofreal-
estateriskanddescriptionofsomederivativesinstrumentsdirectlyrelatedto
theevolutionofmortgagesiscoveredinChapter4.Afulldescriptionofreal-
estate derivatives is provided in Chapter 5 and some real-world applications
are detailed in Chapter 6. The main models that have been proposed in the
literature to help with this new important asset class are discussed at length
in Chapter 7. A new frontier where real-estate derivatives are needed in
relation to property price risk and negative equity insurance is highlighted
inChapter8.Thefinalchapter,Chapter9,summarizesthemainconclusions
coming out of this monograph and also briefly discusses the outlook for
real-estatederivatives.
OUPCORRECTEDPROOF–FINAL,27/2/2017,SPi
ACKNOWLEDGEMENTS
Thisbooktookshapeoveraperiodofeightyears,intheinterestingtimes,for
anacademic,followingthesubprimecrisisof2007andtheseriesofeventsthat
followed.TherearemanypeoplethathelpedmeonthisjourneyandtowhomI
willalwaysbegrateful.Firstofall,IwouldliketothankRobertShillerforbeing
arolemodelandforstartingandperseveringinadvocatingthepromotionof
real-estatederivativesastoolsforstabilityinsociety.Hiscontributioninthis
areaovertimehasbeentrulyoutstandingandinspirationaltomyself.Secondly
IwouldliketothankFrankFabozziforhisconstanthelpandadviceonmany
issuesrelatedtothisbook.
I had the privilege to work with data on futures on IPD from their very
beginning, after they were launched on EUREX. For this and for insightful
discussions on the mechanics of the property futures, I am greatly in debt
toStuartHeathandByronBaldwinandtheirteamatEUREXinLondonfor
theirsupportovertheyears.SpecialthanksarealsoowedtoTonyKeyatCass
BusinessSchool,forveryinterestingdiscussionsonreal-estatederivativesand
for helping me contact other organizations who were doing actual business
inreal-estatederivatives.Iwouldalsoliketoacknowledgethehelpwithdata
fromTraditionGroupinLondon,amarket-makerinpropertyderivatives,and
the RBS real-estate desk, for help with unique datasets that are discussed in
thisbook.
Somepartsofthisbookemergedfollowingjointresearchwithsomewon-
derful colleagues. To this end I am thankful to Silvia Stanescu and Made
ReinaCandradewifortheircooperation,particularlyontheapplicationonthe
arbitragebetweentotalreturnswapsandfuturesmarketsonIPD.Inaddition,
I would also like to thank participants at WHU Campus for Finance 2010,
EFMA, Barcelona 2012, EFMA, Reading 2013, SUERF Property Prices and
RealEstateFinancinginaTurbulentWorld,Copenhagen2013,forusefulsug-
gestions.IamindebtedtoJoaoCocco,MichaelDempster,ArturoLeccadito,
GianlucaMarcato,EkateriniPanopoulou,HashemPesaranforusefuldiscus-
sionsandhintsovertheyears,toAna-MariaDumitru,JasonKynigakis,Tom-
masoPaletta,SherryZhengforhelpwithdataandtoFilipaTunaruforgiving
upherfreetimetoproof-readthemanuscriptofthisbook.
Last but not least I have special thanks to the team at Oxford University
Press,AimeeWright,GayathriManoharan,andAdamSwallowinparticular,
fortheirdedicationandhelponthisproject.