Pricing and index considerations in commercial real estate derivatives - Understanding the basics

It is important for participants in the nascent commercial real estate derivatives market to understand the fundamentals and the subtleties of the appraisal and transaction based indexes that underpin derivatives, as well as the proper pricing of derivatives taking into account the risk and return characteristics of the index. The authors review these considerations including the implications that appraisal lag in the index has for the equilibrium pricing of derivatives' such as index swaps, and the use of such vehicles for hedging real estate risk. An important conclusion is that even if the underlying index does not represent the current equilibrium in the property market or if the property market itself is not in equilibrium, we can still use equilibrium analysis in the derivatives market to derive a fair price for an appraisal index based derivative including consideration of the effect of any lagging and smoothing in the index. The analysis highlights informational issues about indexes and property markets that present both danger and opportunity for the facilitation of a well-functioning property derivatives market in the United States and shows how usage of derivatives needs to consider the effect of possible lag in the index.