Hedging Effectiveness Of Total Returns Swaps: Application To The Japanese Market

The purpose of this paper is to explore the hedging effectiveness of total returns swaps (TRS) in real estate investment. We assume that investors own a real estate portfolio and wish to reduce their exposure to future movements in the property market. They therefore will swap the real estate index for LIBOR plus spread. We first model the cash flow of the resultant portfolio and then analyze the hedging effectiveness both in ex ante terms and with actual returns using a sample, provided by the Association for Real Estate Securitization in Japan, of 74 office properties in the Tokyo metropolitan area over a four year period. The samples of real estate portfolios are constructed randomly and the portfolios range in size from single properties to portfolios of up to 10 properties. The investment horizon varies from 6 months to 24 months. On the basis of this study we conclude that, with a small or zero spread in the total return swap market, investors can s tabilize the return of their portfolios. The ex ante hedging effectiveness, that is, the ratio of the standard deviation of the portfolio returns with and without the hedge in place, ranges from 0.71 to 0.14 and is usually greater than the actual hedging effectiveness which varies from 0.68 to 0.36. However if the spread is non-zero (based on the expected returns), the hedging effectiveness is substantially reduced, because the effect of the spread increases the uncertainty of the hedge portfolio.