A 30-Year Perspective on Property Derivatives: What Can Be Done to Tame Property Price Risk?

Abstract

The housing sector is the largest spot market in the world without a developed derivative contract to serve the risk management needs of market participants. This paper describes the evolution within a wider economic context of property derivatives in the United States and worldwide. We review various economic arguments presented in the literature to highlight the advantages of these financial instruments to society. The paper also provides a critical perspective on the principal obstacles hindering the development of property derivatives based on real estate prices—especially housing prices—and what can be done to overcome these difficulties. The issues discussed can serve as a guide for designing property derivatives capable of hedging real estate risk that has resurfaced time and time again in financial crises.

The Demand for Long-Term Mortgage Contracts and the Role of Collateral

“…Due to the life-cycle trend in LTV, lenders would have to price in a forward-looking path of collateral, and implicitly bear the risk of future house price developments over the fixation horizon of the longer-term contract, in order to make the longer-term contract attractive to high-LTV borrowers. The findings are consistent with lenders requiring compensation for a systematic source of risk, and the lack of financial instruments available to hedge aggregate house price risk, as observed by Shiller (2014) and Fabozzi et al (2020). The findings also provide a general intuition for why the initial insurance benchmark does not hold, as long-term contracts in markets with systematic risks may command a premium above the expected cost of the short-term contract sequence.…”

“…The fact that longer-term contracts are relatively more costly at high levels of LTV may be consistent with the lack of financial instruments available to hedge house price risk as observed by Shiller (2014) and Fabozzi et al (2020), and lenders requiring compensation for exposure to house price risk as a systematic source of risk.…”

Investor sentiment: a retail trader activity approach

“…Similarly, home prices have shown record price appreciation [20]. Recent research considers home prices and related derivatives in the context of noise trader risk (Fabozzi et al , 2020; Uluc, 2018). Considering cryptocurrency, Liu and Tsyvinski (2020) consider momentum in the context of noise traders.…”

The evolving risks of the 21st century and their effective management

“…( Akerlof and Shiller, 2009 , Benford et al, 2018 , Boxell and Shapiro, 2017 , Fabozzi et al, 2020 , Grey, 2020 , Hall and Kudlyak, 2019 , Hall, 2021 , Kahn, 1931 , Kermack and McKendrick, 1927 , Marshall, 1920 , Shiller, 2019 , Shiller, 2003 , Shiller, 2020 , Sunstein, 2017 )…”