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.