Derivatives: Sinking equities markets drag down derivatives pricing

Pricing for 2012 contracts plummeted from 4% in late July to 1.5% this month, reflecting the gloomier economic outlook

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Property derivative pricing has shown it’s not immune to shocks quickly filtering through from core financial markets, writes Sam Whitham. US and European sovereign debt issues, which caused the FTSE to plummet 15% in early August, have caused a downward shift in the total returns being forecast by derivative pricing.

Bids for longer dated contracts were pulled down rapidly, forcing the pricing curve down. With the 2011 annual contract only four months from maturity, and the lag in the economic effect on the physical property market, pricing at the front of the curve did not fall to the same degree.

In the first two weeks of August, 2011 contract pricing fell from 7% to 6.5%, reflecting a slightly more bearish outlook for the rest of the year. This has since recovered to 6.75%, after  August IPD figures showed flat capital values. But from a level of 4% total return in late July (the contract’s price since early April), 2012 pricing recently fell to 1.5%. This implies commercial property values will fall around 5% in 2012.

IPD July and August figures showed that capital appreciation had ground to a halt, with offices the only sector where capital values rose, by 0.64%. Retail capital values fell for the first time in two years and it was the weakest sector during the period, slumping 26bps. Industrial property values fell for the fourth consecutive month.

IPD All-Property Index returns in the year to date have reached 5.4%. If capital growth is flat for the remainder of the year, IPD would be expected to return 7.35%. Annual contracts for  2011 are priced at around 6.75%, meaning derivative prices forecast a 0.6% fall in capital values in the next four months.

All four post-2011 annual contracts continue to forecast  negative capital returns, with 2013, 2014 and 2015 contracts all pricing total returns lower than annual income returns. The August Halifax House Price Index figure, released at the start of September, showed a 1.59% fall in UK house prices on a non-seasonally adjusted basis. Price movements so far this year remain positive, but small, at 0.36%.

With current mid-pricing for a one year HHPI contract at 96%, the contract could be viewed  as cheap if the UK residential market is “insulated from global financial jitters”, as Rightmove suggested last month.

Pricing towards the front end of the curve rose in July, while longer dated contracts remained stable. The four-year HHPI contract traded at 99.75%, but has since moved lower to a  mid-price of around 98.5%, indicating that house prices will fall in the next two years, before crawling back to their December 2010 price level in mid-2015.

With the market movements seen over the previous few weeks, the volume of property derivative trades has increased as people take a view on where value lies within contract pricing. Structured notes have become a more attractive investment, as outperformance of IPD can be automatically achieved by purchasing a 2012 note, which offers IPD total return plus 50bps.