A model for pricing real estate derivatives with stochastic interest rates

Abstract

The real estate derivatives market allows participants to manage risk and return from exposure to property, without buying or selling directly the underlying asset. Such a market is growing very fast hence the need to rely on simple yet effective pricing models is very great. In order to take into account the real estate market sensitivity to the interest rate term structure in this paper is presented a two-factor model where the real estate asset value and the spot rate dynamics are jointly modeled. The pricing problem for both European and American options is then analyzed and since no closed-form solution can be found a bidimensional binomial lattice framework is adopted. The model proposed is able to fit the interest rate and volatility term structures.