Risk-neutral valuation of real estate derivatives

We propose a novel and intuitive risk-neutral valuation model for real estate derivatives. We first model the underlying efficient market price of real estate and then construct the observed index value with an adaptation of the price update rule by Blundell and Ward (1987). The resulting index behavior can easily be analyzed and closed-form pricing solutions are derived for forwards, swaps and European put and call options. We demonstrate the applicationof the model by valuing a put option on a house price index. Autocorrelation in the index returns appears to have a large impact on the option value. We also study the effect of an over- or undervalued real estate market. The observed effects are significant and as expected.