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.