Online Money Manager

In a world of perfectly complete and efficient markets, derivatives would be redundant. They could be replicated by a combination of the underlying asset and other securities. Nobody would need a call option if its exact payoff could be achieved just by trading the underlying security. In reality, however, derivatives serve purposes that cannot be implemented by other instruments. Many underlying instruments are not directly tradable themselves, e.g. interest rates or inflation. In many aspects, derivatives have made markets more complete and efficient.

The larger the frictions in the base market, the greater is the potential benefit derivatives can create. These benefits include, among others, a reduction in transaction costs, an acceleration in transaction speed and an improvement in information availability. Real estate seems to be a perfect candidate for a derivatives market.

A market is liquid if large volumes can be traded anytime, without affecting market prices. The liquidity of the property market is low compared to its market size. Turnover in the real estate market is much lower than for most security markets. Moreover, in market downturns, turnover and liquidity “dries out.” The illiquidity of the property market arises mainly due to its heterogeneity, and certainly not due to a lack of market participants.

In an illiquid base market such as the property market, derivatives can ease the transfer of risk and thus be of great benefit to market participants. Unlike some of the more exotic classes of derivatives that have been launched in recent years, property derivatives have a very simple appeal and a potentially huge base of end-users. They allow managing property risk quickly and cheaply, removing long transaction lead times and saving on transaction costs.

Comments are closed.