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estimate the total transaction cost for property in the UK to be about 3% to 9% including property taxes. Transaction costs for derivatives on the other hand are negligible.

Transaction time

It is not only costly but also time consuming to trade physical property. Due diligence processes, price negotiations and the closing of a contract are time consuming. Furthermore, there are extensive search efforts to find the counterparties with the best offer. Also, the heterogeneity of properties and their unique spatial component suggest it is time consuming to identify suitable objects. It is a fact that the property market is not quite transparent. In many regions and for some sub-markets, very few comparable transactions can be observed to indicate a price level. Consequently, uncertainty about demand and price for an individual object is high. The result is often a large difference between the prices of bidders and sellers since both sides want to be compensated for the price uncertainty. In other words, transaction time reflects market illiquidity. In the UK, it takes on average three months to find a counterparty and another three months to finalize a transaction.4 Derivatives in contrast can be traded almost instantly.

Short sale constraint

Shorting an asset is not simply the mirror image of buying an asset for various legal and institutional reasons. To be able to sell an asset short one must borrow it. The borrower pays a lending fee to the lender.

To illustrate the effect of a short sale constraint on the no-arbitrage condition, consider the cash and carry relationship. For a stock, cash and carry arbitrage works as follows: the fair price of a forward contract must equal the price of the underlying stock plus financing costs minus forgone dividends. If this relation does not hold, then cash and carry arbitrage can be achieved. For a forward price lower than the fair value, the arbitrageur would enter a long position in the forward contract, sell the stock short and lend the proceeds to earn interest. This second case involves the need to sell the underlying asset short. Short selling is generally not possible for the properties that make up an index, since one cannot lend and sell short buildings. Because of the short sale constraint, arbitrageurs can only refrain from buying overpriced assets but cannot exploit mispricings. Miller (1977) describes how short sale constraints can cause prices to reflect only the views of optimistic investors.

4According to experts of the investment bank Calyon and of the brokerage firm TFS, 2nd Pan-European Property Derivatives Conference, May 8/9, 2008, Barcelona, Spain.

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