OUP CORRECTED PROOF – FINAL, 27/2/2017, SPi Real-Estate Derivatives OUP CORRECTED PROOF – FINAL, 27/2/2017, SPi OUP CORRECTED PROOF – FINAL, 27/2/2017, SPi Real-Estate Derivatives From Econometrics to Financial Engineering Radu S Tunaru OUP CORRECTED PROOF – FINAL, 27/2/2017, SPi Great Clarendon Street, Oxford, OX2 6DP, United Kingdom Oxford University Press is a department of the University of Oxford It furthers the University’s objective of excellence in research, scholarship, and education by publishing worldwide Oxford is a registered trade mark of Oxford University Press in the UK and in certain other countries © Radu S Tunaru 2017 The moral rights of the author have been asserted First Edition published in 2017 Impression: All rights reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, without the prior permission in writing of Oxford University Press, or as expressly permitted by law, by licence or under terms agreed with the appropriate reprographics rights organization Enquiries concerning reproduction outside the scope of the above should be sent to the Rights Department, Oxford University Press, at the address above You must not circulate this work in any other form and you must impose this same condition on any acquirer Published in the United States of America by Oxford University Press 198 Madison Avenue, New York, NY 10016, United States of America British Library Cataloguing in Publication Data Data available Library of Congress Control Number: 2016956900 ISBN 978–0–19–874292–0 Printed and bound by CPI Group (UK) Ltd, Croydon, CR0 4YY Links to third party websites are provided by Oxford in good faith and for information only Oxford disclaims any responsibility for the materials contained in any third party website referenced in this work OUP CORRECTED PROOF – FINAL, 27/2/2017, SPi This book is dedicated to my wife Diana, thanking her for her longstanding support and remarkable infinite kindness in the face of adversity OUP CORRECTED PROOF – FINAL, 27/2/2017, SPi OUP CORRECTED PROOF – FINAL, 27/2/2017, SPi P R E FACE Recently financial derivatives were portrayed as “weapons of mass destruction” by famous investors like Warren Buffett This was not that long after he tried to buy Long Term Capital Management (LTCM) on the cheap, unsuccessfully Should we really be worried about financial derivatives? First of all there is evidence that they were used as far back as 8000 B.C by Sumer traders to lock in contracts in to the future and take advantage of seasonality Thus, financial derivatives have been around for a long time and so far, there has not been a mass destruction They could be used though to destabilize financial systems and in the last three decades almost all financial disasters involved financial derivatives But this does not make Warren Buffett right Antibiotics can also have a detrimental effect on millions of people if they are used wrongly Still, I not believe that we should eliminate antibiotics and likewise, I not believe that we should stop using derivatives What famous people perhaps should argue for is not to use financial derivatives where they are not needed Given that apart from forwards/futures and swaps the majority of financial derivatives have nonlinear payoffs, they can be 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 move into the hands of speculators Are derivatives needed by society? The most developed economies are dominated by real-estate which represents a very large part of total wealth The crashing of property markets around the world has led to periods of recession and instability It seems paradoxical that exactly where they are needed the most, in real-estate, derivatives are in infancy Hopefully this book will motivate those in key positions to act immediately and help the expansion of realestate derivatives There is a general lack of knowledge of real-estate derivatives and this book is aiming at offering academics, investors, regulators, hedgefund managers, risk managers, model validators, postgraduate and research students in Finance and Real-Estate, a valuable source of information that can serve them as a guide in their activities It is assumed that the reader has basic knowledge of financial markets, financial modelling, financial economics and statistics The analysis presented in this book can be carried out with Excel and Matlab and many datasets used in this book are in the public domain While working on the RMBS desk in London at Merrill Lynch I came across 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 OUP CORRECTED PROOF – FINAL, 27/2/2017, SPi viii PREFACE UK market Given the size of the residential mortgage backed securities I have thought that there must be a wide range of derivatives covering house prices offered by the banks This proved to be wrong and there started my journey in this important area of finance 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 years to come but I hope that the evolution of real-estate derivatives will not be hindered by the new political climate There is a need for real-estate derivatives in order to stifle out speculation on property markets that are detrimental to us all The big question is how to kick-start this market when the property markets stay for long time on a bull run reaching bubble states The property owners would like to hedge the value of their properties and they would be naturally short on these property derivatives The banks should be long property price 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 ask top banks to show the effects of a market downturn in real-estate on their portfolios Property derivatives would help banks manage this enterprise risk management exercise This seems to me to be the way forward Organization of the Book This book can be used for a graduate class on real-estate finance and as an elective module on MBA and postgraduate research programmes in finance Ultimately, the specialists working in investment area with exposure to realestate price risk need to be aware of several facets of this type of risk, which are hopefully captured in the chapters of this book Chapter presents the main real-estate indices used worldwide for investment purposes and on which derivatives contracts are very likely to be issued For investors in financial markets, mortgages are the natural carrier of real-estate risk Thus, an introduction to this asset class is given in Chapter The distribution of risk resulting from holding mortgage loans has been done in recent years through the channels of securitization The involvement of realestate risk and description of some derivatives instruments directly related to the evolution of mortgages is covered in Chapter A full description of realestate derivatives is provided in Chapter and some real-world applications are detailed in Chapter The main models that have been proposed in the literature to help with this new important asset class are discussed at length in Chapter A new frontier where real-estate derivatives are needed in relation to property price risk and negative equity insurance is highlighted in Chapter The final chapter, Chapter 9, summarizes the main conclusions coming out of this monograph and also briefly discusses the outlook for real-estate derivatives OUP CORRECTED PROOF – FINAL, 27/2/2017, SPi ACK N O W L E D G E M E N T S This book took shape over a period of eight years, in the interesting times, for an academic, following the subprime crisis of 2007 and the series of events that followed There are many people that helped me on this journey and to whom I will always be grateful First of all, I would like to thank Robert Shiller for being a role model and for starting and persevering in advocating the promotion of real-estate derivatives as tools for stability in society His contribution in this area over time has been truly outstanding and inspirational to myself Secondly I would like to thank Frank Fabozzi for his constant help and advice on many issues related to this book 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 to Stuart Heath and Byron Baldwin and their team at EUREX in London for their support over the years Special thanks are also owed to Tony Key at Cass Business School, for very interesting discussions on real-estate derivatives and for helping me contact other organizations who were doing actual business in real-estate derivatives I would also like to acknowledge the help with data from Tradition Group in London, a market-maker in property derivatives, and the RBS real-estate desk, for help with unique datasets that are discussed in this book Some parts of this book emerged following joint research with some wonderful colleagues To this end I am thankful to Silvia Stanescu and Made Reina Candradewi for their cooperation, particularly on the application on the arbitrage between total return swaps and futures markets on IPD In addition, I would also like to thank participants at WHU Campus for Finance 2010, EFMA, Barcelona 2012, EFMA, Reading 2013, SUERF Property Prices and Real Estate Financing in a Turbulent World, Copenhagen 2013, for useful suggestions I am indebted to Joao Cocco, Michael Dempster, Arturo Leccadito, Gianluca Marcato, Ekaterini Panopoulou, Hashem Pesaran for useful discussions and hints over the years, to Ana-Maria Dumitru, Jason Kynigakis, Tommaso Paletta, Sherry Zheng for help with data and to Filipa Tunaru for giving up her free time to proof-read the manuscript of this book Last but not least I have special thanks to the team at Oxford University Press, Aimee Wright, Gayathri Manoharan, and Adam Swallow in particular, for their dedication and help on this project ... 27/2/2017, SPi Real- Estate Derivatives OUP CORRECTED PROOF – FINAL, 27/2/2017, SPi OUP CORRECTED PROOF – FINAL, 27/2/2017, SPi Real- Estate Derivatives From Econometrics to Financial Engineering. .. property index total return swap 140 6.2 A cross-sector real- estate total return swap 141 6.3 Managing real- estate exposure using a real- estate derivative (RED) contingent on a real- estate index... opposed to bond markets or equity markets where an investor has a flurry of financial products to choose from for various risk-return profiles, financial innovation seems to be lagging for real- estate