Real Estate Derivatives: An Application to Italy

Real estate is considered one of the oldest and biggest asset classes that investors can analyze and invest into. The importance of real estate as a main source of wealth has increased over time, resulting in an increment of property exposures in portfolios of most investors. More recently, the property market has assisted to the inclusion of many new vehicles in the real estate finance, with the objective of increasing the range of investment opportunities for investors. This process has brought real estate much deeper into capital markets, with the main aim to recapitalize the asset class and to exploit all its potentialities. The integration of the real estate sector into capital markets has partially modified how the property market works, making the two interdependent. However, none of the new market characteristics or products have implied that the risk of investing in real estate has been completely removed or significantly decreased. It just means that market functionalities and instruments have changed, and so the investment and risk management processes have begun to be adapted to this new environment, according to their objectives and resources. In this scenario, the recent introduction of new financial instruments as the property derivatives enables to manage easily and flexibly the risk--return profile of a real estate, to hedge and transfer property risk, and to optimize investment portfolios. These instruments represent an opportunity to further revolutionize financial systems, even if most markets where they are traded are still illiquid and at an embryonic stage. One can ask why these real estate derivatives are still rare and there is not an adequate large demand for them; a demand that should even be greater than that of all other derivatives markets, since real estate risks are typically higher and more significant than those of many other asset classes that are well set up in financial markets. This fact can be explained, other than the not complete awareness of real estate risks, by the special characteristics of the real estate asset class. Given the specific characteristics of the property market, it is not possible to price real estate derivatives by using a classic and unique no--arbitrage framework. Therefore, two alternative and different pricing models are separately analyzed and, subsequently, an integrated approach of the two frameworks is carried out. The first alternative pricing method is based on Syz\&Vanini (2009) and it derives an arbitrage free price band for property derivatives by considering the property spread as a price measure in a market, as the real estate one, that is incomplete and characterized by significant frictions. The second alternative pricing approach regards the use of a novel and quantitative risk--neutral valuation model developed by Bragt et al.~(2009), whose main objective is to build up a method for pricing real estate derivatives that takes into account the fact that the property market is less informationally efficient than public securities ones. Therefore this pricing method deals with the positive autocorrelated dynamic of a real estate index. In conclusion, the delineated alternative theory is used for pricing potential real estate derivatives based on the Italian property market. Even if Italy is still young in the property derivative debate, it has all the characteristics for exploiting significant benefits from this research area.