An Evaluation of the Developmental Issues and Potential for Real Estate Derivatives

Over the last decade financial innovation has brought about an explosion in financial contracts that allow market participants to tailor their financing needs to match almost any cash flow or risk profile. It is now possible to shift virtually any type of financial price risk or alter a cash flow stream by entering into one, or a combination of, the many types of exotic financial derivatives that are readily available in the financial markets. Though estimates differ, the underlying notional principal of financial derivatives worldwide is now almost certainly in excess of $60 - $70 trillion and could be significantly greater if an accurate accounting were possible. Many market specialists think that we are just beginning to see the myriad of applications of financial innovation, or financial engineering, and the theoretically unlimited types of derivative contracts that make this innovation possible. The use of derivative contracts is not yet wide spread in the management of investment real estate, however, it is almost surely just a matter of time before the marketplace will bring forth derivative contracts designed to meet the risk management and financing need of not only real estate investors, but the needs of all parties involved in a real estate transaction. While the securitization and derivatization that has become so widespread in the general business and securities investment sectors may not seem applicable to real estate transactions, which is not the case. The marketplace, through innovative intermediaries such as Bankers Trust, Solomon Brothers and others, has demonstrated the ability and desire to supply derivative products for almost any perceived need. It only remains for real estate market participants to begin to think about what type of financial structures and risk management issues can be addressed in the market place of financial innovation. A primary issue in the development of real estate derivatives is the performance measurement used for the underlying asset. For other asset class derivatives, such as interest rate and common stock derivatives, this is not much of an issue since the underlying trades frequently in an organized market with instantaneous reporting. Unfortunately, for real estate this type of price information is only available for REIT stock, which arguably does not appropriately reflect the performance of the underlying real estate. This paper is an exploration of the potential for, and feasibility of, innovative financial instruments written on a broad array of real estate. Section one of the paper looks at potential users of real estate derivatives and the applications derivatives might find. In section two, a number of potential derivative contracts are identified which could meet the needs of the potential users. The third section deals with the pricing issue and examines various measures of real estate price and rent performance, which could be used to model derivative prices. The fourth section evaluates the behavior of the properties of options written on a specific index by testing the theoretical conformity of the optionís ìGreeksî. Finally, the conclusion of the paper addresses avenues of exploration, which should be fruitful in aiding the process of financial innovation in real estate.