Real Estate Volatility Index: An Application of the State Preference Approach

Abstract

This paper develops a real estate volatility index (RVX) based on Real Estate Investment Trusts (REITs) over an extensive period of 1996-2012. In line with the Chicago Board Options Exchange (CBOE) Volatility Index (VIX), our RVX, computed on a daily basis, is an ex-ante measure of the next 30-day real estate volatility. The state preference approach employed does a good job in incorporating different market conditions and special economic events into RVX. Thus, our RVX has a reasonably high correlation of 0.85 with the realized volatility of REITs and for all practical purposes, is unbiased. As the first attempt aiming at creating a core systematic risk measure for the real estate market, our RVX can serve as a specialised investor fear gauge for this important asset class and supplementing other indices such as VIX and the Merrill lynch Option Volatility Estimate (MOVE). In addition, RVX also brings a variety of other significant applications, including being used for a market timing tool, helping shape hedging strategies and as an input to compute a realized-implied volatility spread which might be a predictor for future REIT returns.