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Property derivatives: Bad news is good news

The growing number of investors wanting to short the commercial property market is good news for property derivatives.

The property derivatives market experienced a rush of news in the first few weeks of this year: the first commercial property derivatives swap; the launch of the first property derivatives hedge fund; the first property derivative written on a mainland European IPD index; the announcement by CBOT of its plan to offer commercial property futures; and a new UK residential property index that could boost residential property derivatives. It is a sign of the momentum building in this sector.

Property derivatives have been something of a slow burn, with more talk than action for years. But recent trading volumes published by IPD (Investment Property Databank) show that the cumulative notional value of trades in the most active market – the UK – reached £3.7 billion ($7.3 billion) in the third quarter of 2006. Analysts at Merrill Lynch reckon that a further £4 billion of trading will take place in 2007 to bring the notional value to about £8 billion. It will need to, if it is to support the number of players that are hoping to hitch a ride, and there is still a very long way to go. The Merrill analysts calculate that volumes traded will have to reach £30 billion before the price of underlying property becomes driven by derivatives pricing.

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