Risk mitigation with buy‐back guarantees and guaranteed appreciation plans

Abstract

Two marketing schemes that provide protection against downside price risk are examined. The buy‐back guarantee allows the property purchaser to sell the property back to the developer at the original purchase price, while the guaranteed appreciation plan assures the buyers of a minimum price appreciation at the end of a specified period. Both plans essentially provide the property purchaser with put options with contingent payoffs that differ in terms of the strike price. This paper examines the value of the buy‐back guarantee and the guaranteed appreciation plan as well as providing a framework for evaluating the put options. The key finding is that the time value of such put options is extremely low if they are too deep in‐the‐money and if expected volatility is low. If so, a careful examination of the terms offered suggests that the buy‐back guarantee is expensive. In contrast, the guaranteed appreciation plan can be regarded as a free option because it provides a strike price that is above the purchase price. Hence, property purchasers react favorably to the guaranteed appreciation plan. Finally, implications for marketing and pricing strategies are examined.