Abstract
This paper develops a two-state model for pricing securities dependent upon a real estate index and an interest rate. First, a process governed by an index that is dependent upon real estate asset returns is developed. Second, a real estate and an interest rate process are combined to create a bivariate binomial tree. The resultant model is used to price any derivative security that is dependent on the two underling variables: (1) a real estate index, and (2) the short term interest rate. This model uses a real estate index to capture the volatility in the real estate market thus providing a means to accurately price real estate dependent derivative assets. Finally, this paper demonstrates the model by pricing commercial real estate index linked swaps (CREILS).
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