Risk management with residential real estate derivatives : strategies for home builders

This paper examines why and how publicly-traded home builders might use index-based residential property derivatives to manage risk. After describing a number of alternative reasons for hedging, I argue for a paradigm for risk management proposed by Kenneth Froot, David Scharfstein and Jeremy Stein and augmented by Antonio Mello and John Parsons. According to this paradigm, the objective of hedging is to increase a firm's financial flexibility by maximizing its liquidity - slack in the form of cash or unused debt capacity - when falling output prices reduce income and make it difficult to raise external financing, but do not reduce the firm's need for funds. An important implication of this paradigm is that attempting to eliminate volatility in the value of a firm is not an optimal hedging objective, and attempting to do so can, in fact, reduce the value of the firm. To illustrate how this paradigm might be used by public home builders it is applied to two hypothetical firms, each with a different capital structure and regional focus, and the potential benefits of hedging for each firm is discussed. The discussion then turns to the available real estate derivative products and how they can be employed as hedging vehicles. Key issues pertaining to the design of hedging vehicles are examined, including 1) how to choose a derivative contract, 2) how to choose an index or indices to use as the asset underlying the hedging vehicle and 3) how to address misalignment between the time to expiration of available derivatives contracts and the development time frames of residential communities. Evidence is presented that suggests hedging vehicles based on multi-market composite indices will probably have too much basis risk to effectively hedge against downturns in the prices of some builders' homes.

Department dc:contributor.department

Massachusetts Institute of Technology. Center for Real Estate

Grantor dc:publisher

Massachusetts Institute of Technology

Year dc:date.issued

2008

Author dc:creator

• Eddins, Quinn W. (Quinn William)

Advisor dc:contributor.advisor

• David M. Geltner.

• Urban Studies and Planning.
• Center for Real Estate.

Statement dc:rights

• M.I.T. theses are protected by copyright. They may be viewed from this source for any purpose, but reproduction or distribution in any format is prohibited without written permission. See provided URL for inquiries about permission.

Licence dc:rights.uri

• http://dspace.mit.edu/handle/1721.1/7582

Language dc:language.iso

eng

Handle dc:identifier.uri

http://hdl.handle.net/1721.1/58631

OAI identifier oai:identifier

oai:dspace.mit.edu:1721.1/58631