Valuation and arbitrage

The use of discounted cash flow (DCF) methods in investment valuation and appraisal is argued by many academics as being rational and more rigorous than the traditional capitalisation model. However those advocates of DCF should be cautious in their claims for rationality. The various DCF models all rely upon an all-encompassing equated yield (IRR) within the calculation. This paper will argue that this is a simplification of the risk perception which the investor places on the income profile from property. In determining the long term capital value of a property an 'average' DCF method will produce the 'correct' price, however, the individual short term values of each cash-flow may differ significantly. In the UK property market today, where we are facing a period in which prices are not expected to rise generally at the same rate or with such persistence as hitherto, investors and tenants are increasingly concerned with the down side implications of rental growth and investors may indeed be interested in trading property over a shorter investment horizon than they had originally planned. The purpose of this paper is therefore to bring to the analysis a rigorous framework which can be used to analyse the constituent cash flows within the freehold valuation. We show that the arbitrage analysis lends itself to segregating the capital value of the cash flows in a way which is more appropriate for financial investors

Cross-country effects of regulatory capital arbitrage

One reason for the recent asset price bubbles in many developed countries could be regulatory capital arbitrage. Regulatory and legal changes can help traditional banks to move their assets off their balance sheets into the lightly regulated shadows and thus enable regulatory arbitrage through the securitized sector. This paper adopts a global vector autoregression (GVAR) methodology to assess the effects of regulatory capital arbitrage on equity prices, house prices and economic activity across 11 OECD countries/ regions. A counterfactual experiment disentangles the effects of regulatory arbitrage following a change in the net capital rule for investment banks in April 2004 and the adoption of the Basel II Accord in June 2004. The results provide evidence for the existence of an international finance multiplier, with about half of the countries overshooting U.S. impulse responses. The counterfactual shows that regulatory arbitrage via the U.S. securitized sector may enhance the cross-country reallocation of capital from housing markets towards equity markets.

Trading death: the implications of annuity replication for the annuity puzzle, arbitrage, speculation and portfolios

Annuities are perceived as being illiquid financial instruments, and this has limited their attractiveness to consumers and their inclusion in financial models. However, short positions in annuities can be replicated using life insurance and debt, permitting long positions in annuities to be offset, or short annuity positions to be created. The implications of this result for the annuity puzzle, arbitrage between the annuity and life insurance markets, and speculation on expected longevity are investigated. It is argued that annuity replication could help reduce the annuity puzzle, improve the price efficiency of annuity markets and promote the inclusion of annuities in household portfolios.

The determinants of a cross market arbitrage opportunity: theory and evidence for the European bond market

This paper examines the determinants of cross-platform arbitrage profits. We develop a structural model that enables us to decompose the likelihood of an arbitrage opportunity into three distinct factors: the fixed cost to trade the opportunity, the level at which one of the platforms delays a price update and the impact of the order flow on the quoted prices (inventory and asymmetric information effects). We then investigate the predictions from the theoretical model for the European Bond market with the estimation of a probit model. Our main finding is that the results found in the empirical part corroborate strongly the predictions from the structural model. The event of a cross market arbitrage opportunity has a certain degree of predictability where an optimal ex ante scenario is represented by a low level of spreads on both platforms, a time of the day close to the end of trading hours and a high volume of trade.

Pricing inefficiencies in private real estate markets using total return swaps

Efficient markets should guarantee the existence of zero spreads for total return swaps. However, real estate markets have recorded values that are significantly different from zero in both directions. Possible explanations might suggest non-rational behaviour by inexperienced market players or unusual features of the underlying asset market. We find that institutional characteristics in the underlying market lead to market inefficiencies and, hence, to the creation of a rational trading window with upper and lower bounds within which transactions do not offer arbitrage opportunities. Given the existence of this rational trading window, we also argue that the observed spreads can substantially be explained by trading imbalances due to the limited liquidity of a newly formed market and/or to the effect of market sentiment, complementing explanations based on the lag between underlying market returns and index returns.

The long-term price-earnings ratio

price-earnings ratio;value premium;arbitrage trading rule;UK stock returns;contrarian investment Abstract:  The price-earnings effect has been thoroughly documented and is the subject of numerous academic studies. However, in existing research it has almost exclusively been calculated on the basis of the previous year's earnings. We show that the power of the effect has until now been seriously underestimated due to taking too short-term a view of earnings. Looking at all UK companies since 1975, using the traditional P/E ratio we find the difference in average annual returns between the value and glamour deciles to be 6%. This is similar to other authors' findings. We are able to almost double the value premium by calculating the P/E ratio using earnings averaged over the previous eight years.

The underlying return generating factors for REIT returns: an application of independent component analysis

Multi-factor approaches to analysis of real estate returns have, since the pioneering work of Chan, Hendershott and Sanders (1990), emphasised a macro-variables approach in preference to the latent factor approach that formed the original basis of the arbitrage pricing theory. With increasing use of high frequency data and trading strategies and with a growing emphasis on the risks of extreme events, the macro-variable procedure has some deficiencies. This paper explores a third way, with the use of an alternative to the standard principal components approach – independent components analysis (ICA). ICA seeks higher moment independence and maximises in relation to a chosen risk parameter. We apply an ICA based on kurtosis maximisation to weekly US REIT data using a kurtosis maximising algorithm. The results show that ICA is successful in capturing the kurtosis characteristics of REIT returns, offering possibilities for the development of risk management strategies that are sensitive to extreme events and tail distributions.

Can we explain the dynamics of the UK FTSE 100 stock and stock index futures markets?

If stock and stock index futures markets are functioning properly price movements in these markets should best be described by a first order vector error correction model with the error correction term being the price differential between the two markets (the basis). Recent evidence suggests that there are more dynamics present than should be in effectively functioning markets. Using self-exciting threshold autoregressive (SETAR) models, this study analyses whether such dynamics can be related to different regimes within which the basis can fluctuate in a predictable manner without triggering arbitrage. These findings reveal that the basis shows strong evidence of autoregressive behaviour when its value is between the two thresholds but that the extra dynamics disappear once the basis moves above the upper threshold and their persistence is reduced, although not eradicated, once the basis moves below the lower threshold. This suggests that once nonlinearity associated with transactions costs is accounted for, stock and stock index futures markets function more effectively than is suggested by linear models of the pricing relationship.

“Financial alchemy” or a zero sum game? Real estate finance, securitisation and the UK property market

Following the US model, the UK has seen considerable innovation in the funding, finance and procurement of real estate in the last decade. In the growing CMBS market asset backed securitisations have included $2.25billion secured on the Broadgate office development and issues secured on Canary Wharf and the Trafford Centre regional mall. Major occupiers (retailer Sainsbury’s, retail bank Abbey National) have engaged in innovative sale & leaseback and outsourcing schemes. Strong claims are made concerning the benefits of such schemes – e.g. British Land were reported to have reduced their weighted cost of debt by 150bp as a result of the Broadgate issue. The paper reports preliminary findings from a project funded by the Corporation of London and the RICS Research Foundation examining a number of innovative schemes to identify, within a formal finance framework, sources of added value and hidden costs. The analysis indicates that many of the gains claimed conceal costs – in terms of market value of debt or flexibility of management – while others result from unusual firm or market conditions (for example utilising the UK long lease and the unusual shape of the yield curve). Nonetheless, there are real gains resulting from the innovations, reflecting arbitrage and institutional constraints in the direct (private) real estate market

Office rent determinants: a hedonic panel analysis

It has been frequently observed that office markets are subject to particularly high fluctuations in rents and vacancy levels, thus exposing real estate investors to considerable risk regarding expected future income streams. This paper analyzes the determinants of office rents and their variability over time and across sub-markets to gain insight into the rent price formation and its stability across space and over time. No support is found for the single-market hypothesis which states that arbitrage opportunities effectively align real estate pricing schemes in various parts of city. Instead, the results suggest that the importance of hedonic pricing factors varies both over time and across submarkets.

Agricultural commodity markets : reference point for the real value of a currency

Using monthly time-series data 1999-2013, the paper shows that markets for agricultural commodities provide a yardstick for real purchasing power, and thus a reference point for the real value of fiat currencies. The daily need for each adult to consume about 2800 food calories is universal; data from FAO food balance sheets confirm that the world basket of food consumed daily is non-volatile in comparison to the volatility of currency exchange rates, and so the replacement cost of food consumed provides a consistent indicator of economic value. Food commodities are storable for short periods, but ultimately perishable, and this exerts continual pressure for markets to clear in the short term; moreover, food calories can be obtained from a very large range of foodstuffs, and so most households are able to use arbitrage to select a near optimal weighting of quantities purchased. The paper proposes an original method to enable a standard of value to be established, definable in physical units on the basis of actual worldwide consumption of food goods, with an illustration of the method.

Cross-border capital flows into real estate

This study investigates the determinants of cross-border capital flows into direct real estate markets. In particular, it investigates how existing institutional, regulatory and real estate specific barriers affect cross-border real estate inflows and outflows in a sample of 24 developed and emerging countries, and whether investors seek out targets with lower barriers and regulatory arbitrage. We do not find evidence of significant cross-border institutional or regulatory arbitrage in the real estate market. However, real estate market liquidity is found to be the most important driver of cross-border flows. While many of the institutional barriers included in this analysis do not appear to impact the level of real estate inflows significantly, their presence tends to suppress real estate capital outflows to other countries. Overall, easy access to financial markets, a good economic environment and transparent real estate markets may enhance real estate outflows, while returns and the macroeconomy are found to enhance domestic real estate investment.