Option Theory and Housing Jeff Kelsh

Housing  Owning a house is a right and not an obligation, therefore it is an option.  Option to buy or rent  Although emotional factors exist the issues are set aside

Renting Vs Owning o Renting: -very flexible -high variable costs -no fixed costs -increased disposable income (other investments etc) o Owning: -capital intensive -high fixed costs -more efficient -market value credit constrained -depreciation and inflation rate -taxes, insurance, repairs

 Outcome relatively uncertain – Rent  Outcome relatively known – Own  Graphs: Variable and Fixed cost in relation to volatility (high/low) Rate of Return and Output Rate of Return and Output

Traditional Finance  Option: the right to buy or sell an asset  Almost all factors are known (Sk, So, etc)  Volatility is estimated  Option value tracks that of an underlying asset and has an specified expiration date  Traditionally investments are based upon NPV, therefore the higher the risk the higher the discount rate -uncertainty reduces value, although this is not the case for real options.

Real Options  Different scenarios that could develop at various points throughout the life of the project  If probabilities are positive, initial investment takes place  Parameters are more difficult to define  Option value approaches zero as the opportunity disappears  Uncertainty increases value as flexibility exists in decision making

Real Options Allow for flexibility to address uncertainties as they are resolved Allow for flexibility to address uncertainties as they are resolved  Delay taking on investment  Taking on investment and follow-up investments  Abandon investment  Contraction  Expand  Switch

Parameters 1) Cost benefit ratio of option 2) Exercise price 3) Time to Expiration 4) Risk-Free Rate of Return 5) Uncertainty of projected returns - Value also influenced by the spread between the current price and the exercise price

Theoretical Options Embedded in Ownership and Mortgages  Call Option – invest in the future when uncertainty unfolds favorably (protects investment)  Deferral option - delaying the decision to invest and therefore renting as an example (same as call option)  Put Option – protects homeowner against falling house prices and further deterioration of wealth  Test option – investing a small amount of capital (under uncertainty) in a asset similar to a house etc and experiencing the results

Options Embedded in Mortgage  Payments act as a series of compound options  Refinance option as interest rates fall, as long as interest saving are more than refinance transaction costs  Options, put and default, increase in value as housing prices fall  Abandonment option

 Insolvency main factor in default  Other factors in default:  Sharp decrease in market value of house  Unemployment  Interest rates (minimal)

 Options to expand: -Investment to improve the home -Renting of the home

 The more certain the outcome the less valuable the real options method  Although these theoretical options are there doesn’t mean that they’ll be used correctly  Inability to exercise such options have economic and social costs