Online Money Manager

Derivatives only make sense if the underlying asset exhibits sufficient market risk that many participants are willing to transfer, hedge against and speculate on. The three fundamental requirements for an asset class to be a suitable underlying asset for derivatives seem to be fulfilled by the property market. First, the size of the market is sufficiently large, such that demand to buy and sell exposure should exist sufficiently to make a derivatives market desirable.

However, the size of the spot market alone is not sufficient to qualify the market as a meaningful underlying for derivatives. Second, risk in terms of volatile returns is present, meaning that it makes sense to invest or hedge. Third, a credible index that is accepted as a common benchmark must exist in order to have a reference for payoffs. It will be seen later on that such indices exist in some countries but are not fully established in others.

However, a large part of the property market consists of owner-occupied residential housing. Most homeowners do not consider real estate to be an investment, but only consumption. An emotional component as well as the personal and financial situation in their lives drive the buying and selling decision. Institutional investors, who generally act more rationally on real estate investments, are the primary target for most property derivatives. Involving the limiting factors of low turnover, illiquidity and owner-occupiers, the property market is still large enough for a derivatives market to face sufficient demand and supply.

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