Property derivatives: Is this panic?
by Kanak Patel, Magdalene College, Cambridge.
The bid-offer spread on IPD total return swaps (TRS) is a useful window in to the future for investors who seek to actively manage their exposure to property market risk. The massive convergence from 200bp to 280bp last summer to 20bp to 50bp seen recently on a December 2011 contract is an astounding development. According to a recent study by Kanak Patel and Ricarado Pereira at Cambridge University, Pricing property index-linked swaps with counterparty default risk, the fair spread on TRS depends largely on the volatility of the underlying real estate index.
Under a scenario analysis of loss given default equal to 100%, and the index return volatility of around 30%, the fair spread for a one-year TRS done with a counterparty rated with a Caa-C rating is around 140bp. The IPD indices have displayed relatively low risk compared to stock markets indices, with corresponding high-risk adjusted return. From the end of 2006, we have observed a shift in the market sentiment. The three-year swap mid-price spread has been steadily declining, which suggests that investors are expecting a cooling off of the property market. The mid-price of the contract in February was negative, implying that the underlying index of the contracts is expected to have a return below Libor.