Risk-neutral valuation of real estate derivatives

Despite the importance of residential real estate as both an asset class for investors and as a source of “housing services” for individual home owners, as well as the relatively high volatility in house prices, markets for derivative instruments to hedge these risks have been slow to develop. The numerous problems include developing a satisfactory price index upon which derivative contracts could be written, given extensive heterogeneity in the underlying housing stock, sluggish adjustment of prices in a market marked by great illiquidity, strong seasonality in supply and demand, and of course, the fact that dynamic arbitrage between a real estate derivative and the underlying is not feasible. The authors begin with an “efficient market process” for the true value of the index and construct a “real estate index process,” eventually ending up with closed-form valuation equations for forwards, swaps, and options on the index. An empirical investigation of the Dutch real estate market shows that the approach performs well and illustrates the strong effect of autocorrelation in prices.