Stripping of Real Estate-Indexed Swaps and Forward Term Structure: Interest and Computational Method

Abstract

The recent growth of the real estate indexed derivatives market calls for a greater attention to the pricing of these products. This paper contributes to the literature providing a simple connection between instruments such as year on year zero coupon swap or real estate indexed forwards. A closed-form formula for property swaps based on indexed forwards is established and special attention is paid to the convexity adjustment problem. Finally, we introduce a bootstrap method to compute the implied forward term structure using the swap prices. This simple framework enables market practitioners to obtain valuable information from the derivative market for their investment decisions and their risk management. Indeed, forward prices are generally an advanced indicator of future spot prices.

Keywords: swap, forward, term structure, diffusion process, change of probability measure.