Testing alternative models of property derivatives: the case of the City of London
Abstract
Purpose
The paper aims to conduct an empirical study of three models of property derivatives: index-based derivatives, factor hedges, and combinative hedges based on index and factors. The objective is to test whether the latter two models introduced by Lecomte dominate the index-based model used for existing property derivatives such as EUREX futures contracts.
Design/methodology/approach
Based on investment property database (IPD) historical database covering 224 individual office properties from 1981 to 2007, the study assesses ex ante hedging effectiveness of the three models. Nine simulations are run under different hypotheses involving individual buildings and portfolios. The 17 factors included in the study cover both macro-factors (e.g. macroeconomic indicators) and micro-factors linked to the properties (e.g. age).
Findings
Atomization and periodic rebalancing of property derivatives' underlying make it possible to substantially increase hedging effectiveness for a large majority of buildings in the sample. However, combinative hedges are overall superior to factor hedges owing to the overriding role played by IPD indices in capturing risk.
Research limitations/implications
Due to confidentiality requirements inherent to the use of property level data, the study downplays the role of micro-factors on real estate risk at the property level.
Practical implications
The paper introduces a typology of optimal hedges aimed at individual property owners and portfolio holders in the City office property market.
Originality/value
This is the first time a comprehensive analysis of different models of property derivatives is conducted. The value of the paper stems from the use of property level data.
Keywords
Acknowledgements
The author would like to thank all the persons who have made this research possible, in particular Professor Bryan MacGregor and Professor Rainer Schulz at Aberdeen University (Scotland, UK) where this research started. He is also grateful to the following individuals for helping in accessing data used in the research: Professor Colin Lizieri (Cambridge University), Will Robson and members of the Property Derivatives Interest Group (Investment Property Forum), and Malcom Fordsham (IPD London). All errors and omissions are that of the author.
Citation
Lecomte, P. (2014), "Testing alternative models of property derivatives: the case of the City of London", Journal of Property Investment & Finance, Vol. 32 No. 2, pp. 107-153. https://doi.org/10.1108/JPIF-11-2013-0064
Publisher
:Emerald Group Publishing Limited
Copyright © 2014, Emerald Group Publishing Limited