“A 30-Year Perspective on Property Derivatives: What Can Be Done to Tame Property Price Risk?” Fabozzi, Frank J., Robert J. Shiller, and Radu S. Tunaru Flashcards
What is the main idea?
To offer a perspective on the principal obstacles slowing down the development of financial derivatives based on real estate prices—especially housing prices—and what could be done to overcome these difficulties.
Looks into why property derivatives are generally unsuccessful
What is the main problem discussed?
Movements in property prices possess severe risks to their holders, an obvious example being the Great Financial Crisis (2008)
◦ We have a well-established derivatives market for many assets, including stocks, gold, coffee beans, and other commodities, that allow, among other things, to hedge against risk
◦ But the market for property derivatives is “in a state of infancy”
What are the advantages of real estate derivatives?
o Improved information about the path of future prices
o Hedging against housing price risk
(Banks can hedge against default risk, young households can buy futures if housing prices grow faster than their income, more insurance products)
o A tool for broadening investment portfolios (can get exposure to real estate without owning it)
o A basis for new financial products (can design reverse mortgage)
Why Did the Need for Real Estate Derivatives Rise in the 1970s?
◦ Acceleration of property price growth; before that, the prices were mostly rising slowly
◦ Unpreparedness of covered mortgages and mortgage-backed securities for elevated inflation of 1970s
◦ Shift to adjustable rate mortgages; previously, mortgages have been balloon payments
What are the obstacles to a more complete development of a property derivatives market?
o Problems in matching a suitable property index to the property derivatives (different ways to measure real estate market value)
o Concerns about a limited nr of parties in the market (who would be willing to provide insurance against a fall in prices?)
o Problems of modelling property derivatives (creating a pricing model is a challenge)
o Concerns about how regulations may affect the participation of large financial institutions in these markets (as a result of GFC, trading property derivatives became very capital-intensive for banks, so they quit the market)
What are the 3 channels by which price futures may affect house prices?
o Noise traders can buy derivatives of housing futures instead of buying the house – depending on their outlook, trades in future market can increase or decrease volatility of house prices
Derivatives are more liquid and markets quicker
o Housing futures market allows for short selling
o When house price futures overall become attractive to sophisticated investors, the volatility of house prices decreases
What is a reverse mortgage?
Homeowner receives periodic payments for a fixed period or life, secured by the value of the property that will be sold after death
o Concern: risk of a decline in property values
o In the deal there is an insurance policy against house price decline (put option)
What are covered bonds?
A hybrid between corporate bonds and mortgage-backed securities (other financial instrument that protected the originators of mortgage loans from risk of fluctuating housing prices)
What are CMOs?
Collateralized mortgage obligation, new type of mortgage-backed security created in 1980s.
What are the benefits associated with house price derivatives when utilized to manage risk?
o Increasing the financial system’s stability
o Ability of millions of homeowners to manage property risk more cost-effectively
