Case Studies

All the transactions in the case studies exclude transaction costs. Transaction costs are approximately 1% of the notional value, but costs vary depending on size of trade, length of contract and other factors.

Example 1: The Insurance Company

Insurance Company X has allocated $100 million for the New York office market and has been unable to identify appropriate assets. As an alternative, they can create the same exposure via a 2-year swap based on the New York Office index. Insurance Company X will earn the returns over this period as measured by this index and they will pay LIBOR plus a negotiated spread* (150 basis points for this example). The other side of this transaction might be held by a private investor who owns many office buildings and is eager to reduce their overall exposure to the market.

Assume that LIBOR is 5% at the end of the first year and the index return is 11.5%. Insurance Company X receives the value of the index times the notional value or $11.5 million. They also agreed to pay LIBOR plus 150 basis points or $6.5 million.

The short has the opposite cash flow, paying the New York Office index return, $11.5 million and receiving LIBOR plus 150 basis points, $6.5 million.

When the two flows are netted, the short pays $5 million to Insurance Company X. The difference in returns (11.5% - 6.5%) times the notional value is equal to 5 million dollars.

LIBOR is 4.5% at the end of the second year and New York office returns are 6%. The value of the transaction is equal and neither party has to pay the other.

*Basic finance shows that in market at equilibrium the ex-ante expected return is the risk-free interest rate. As the risk level increases, the returns increase to compensate for that risk, but the expected return remains the risk-free rate. Therefore, easiest way to think about spreads over LIBOR, in this and the following examples, is that they represent the additional payment needed to bring the ex-ante expected return back to the risk-free rate. A more thorough explanation is available in most basic finance text books.

Example 2**: The Regional Bank

Regional Bank A has exposure to the southern office market and wants to reduce that exposure by $50 million while adding some geographical diversity to the portfolio. Regional Bank B has exposure to western office and wants to reduce exposure by $50 million and is eager to broaden their geographical exposure. The parties agree to a three year swap of returns and Bank A agrees to pay Bank B 60bps per year***.

Assume the returns for South Office for the three years of the swap are 10.5%, 8.14% and -0.3%. The West Office returns are 10.6%, 9.25% and -0.1%. At the end of the first year, Bank A would pay Bank B $250,000. Bank A pays the $300,000 for the initial difference in returns less the $50,000 from the West Office market outperforming the South Office market by 10 basis points. At the end of the second year, Bank B pays Bank A $255,000. The annual difference in returns is $555,000, 9.25%-8.14% times fifty million, less the $300,000. Finally, in the third year, Bank A pays Bank B $200,000. That is calculated by taking the $300,000 that Bank A owes Bank B less $100,000 from the difference in returns times the notional sum.

**This transaction is actually two separate transactions. Bank A is selling short South Office and going long LIBOR plus some amount and Bank B is agreeing to go long South Office and short LIBOR plus some amount. Bank A is also going long West Office and short LIBOR plus some amount and Bank B is doing the reverse. By combining the two transactions you get Bank A long West Office less 60 basis points and Bank B long South Office plus 60 basis points.

***The 60 basis points is the net difference between the risk adjusted forecast for southern returns and western returns that both parties agree to. No transaction can occur without both parties agreeing to an ex-ante risk adjusted forecast on the future so that they agree on a transaction price.

Example 3: The Regional Bank

Regional Bank C has exposure to the southern office market and wants to reduce that exposure by $100 million. Regional Bank D has exposure to southern apartments and wants to reduce exposure by $100 million. The parties agree to a three month swap of returns. The parties agree Bank D should pay 5 basis points a month ($50,000) to Bank C in addition to the difference in monthly returns.

Assume the returns for South Office for the three months of the swap are 0.3%, 0.12% and -0.3%. The South Apartment returns are .25%, .2% and -.5%. At the end of the first month, they are even. Bank D owes the $50,000 for the 5 basis points and Bank C owes $50,000 based on performance. The two cancel each other out. At the end of the second month, Bank D pays Bank C $130,000, the monthly difference in returns ($80,000) plus the 5 basis points ($50,000). Finally, in the third month, Bank C pays Bank D $150,000, the difference in returns, $200,000, less the 5 basis points.

This example assumes that the return series does not change. The index is published one quarter after the calculation. So the July data is published in September. It is then revised in October and November. Therefore, in the example above, the Banks would settle three months after the return month and allow another two months to "true up" the return series. After that time period, the return series is locked and not revised.

Example 4: The Hedge Fund

Suppose a hedge fund investor has a view that the primary office markets will outperform the rest of the nation's office markets. Historically, such a market bias could never be implemented. Now, this investor can engage in a swap arranged by REAL. This firm can go long a custom index based on primary market returns (Top 10 MSA Office) and go short the national index (National Office). To do the transaction, the hedge fund must pay 200 basis points to the counter party. The swap is for three years with $100 million notional value.

During the first year, primary markets out perform national markets by 400 basis points. Therefore, the short must pay the hedge fund $2 million. The returns for the second year are reversed and national markets outperform primary markets by 25 basis points. The hedge fund pays the short $2,250,000. In the third year, primary markets outperform by 100 basis points. Even though the primary markets outperformed, the hedge fund must pay the short $1 million.

The hedge fund made $1 million on the performance, but had to pay $2 million for the trade, thus a net loss of $1 million.

Example 5: The Closed End Fund

Closed-end fund C is liquidating its assets. It has sold most of its assets, but has an apartment building and a shopping center in the west worth $150 million still to sell. To protect itself from a market downturn, the Fund buys puts on the West All Property index that expire in one year. Even though the Fund owns two different property types, it is more concerned about the region. The fund wants to protect itself against a regional downturn rather than changes in property types.

The current index value is 115. The Fund wants to protect itself against a downturn greater than 7%. Therefore it chooses a strike price of 107 for the index. The volatility of the index is 7% annually and the risk-free interest rate is 6%.

The cost of buying a put with those parameters is $0.09 per index point or $86,072 per million. Assuming the fund wants to buy 150 puts to cover its risk, the total cost to the fund is $13 million dollars. The fund could sell some of its upside gain to offset the cost.

It could sell calls with a strike price of 140 at a price of $0.08 per index point or $82,892 per million. The value of selling 150 calls is over $12 million. This collar, limiting the downside while selling some of the upside, would cost less than $1 million.

Example 6: The Open End Fund

Open-end Fund E receives $50 million a month from shareholders. They cannot place the money quickly enough. Fund E is considering the purchase of several properties, but no contracts exist nor is a close likely in the next three months. How then can it put the money to work getting real estate returns? It can choose to buy a $50 million forward contract of the National index on a monthly basis for three months. For such a contract, each 100 basis point (1 percentage point) move is worth $500,000.

Assume the index value is 100 when Fund E enters into the forward agreement as the long on January 1. Both parties agree to a contract the index value will be 103. Thus, any deviation from 103 will be paid by one of the two parties. If the index value is less than 103 then Fund E pays the other party. If the index is above 103, the Fund E receives money.

When the index is published in June for the March value, it is equal to 101.1. Real estate increased 110 basis points or 190 basis below the agreed upon forward price. Therefore, Fund E must pay the short $950,000.

Since Fund E knows it won't be able to place the money from February until the spring, it can enter a two month forward contract that month. Assume the value of the index at the end of January is 100.5. Fund E and the short agree on a two month forward contract at an index value of 101. As we already know, the value of the index at the end of March is 101.1. The short pays Fund E $50,000.

A third contract for one month can be entered into at the beginning of March. The agreed upon final value is 101. This time the short pays $10,000. As the contracts expire, the funds used as collateral become available and Fund E can access them to purchase assets.

Example 7: The Open End Fund

Open-end Fund E is underweighted in northeast retail, but believes northeast retail will be the best performing sector over the next 24 months. All of its cash is allocated, yet Fund E can still gain exposure to northeast retail by buying a forward contract. Fund F thinks that northeast retail is overbought and expects values to decline. The current index is 110 and the two funds agree on an index value 24 months from now of 120. The actual value of the index at that time is 130. Since each 100 basis points is $500,000 and the difference is 1000, Fund F pays Fund E $5 million.

Example 8: The Regional Bank

Regional Bank Y wants to protect its loan-to-value (LTV) ratio on its office loan portfolio by buying puts that are 10% out of the money. Hedge Fund Z thinks the market won't fall that far and is willing to sell the puts. The puts are based on the East Office index over a one year time horizon. The current index value is 150. Using a strike price of 135, a volatility of 8% and a risk-free interest rate of 5%, then the puts cost $0.11 per index point or $109,902 per million dollars. Bank Y can gain downside protection of $100 million for the cost of $11 million.

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