Pricing Property Index Linked Swaps with Counterparty Default Risk

This paper extends Bjork and Clapham (Journal of Housing Economics 11:418–432, 2002) model for pricing real estate index total return swaps. Our extension considers counterparty default risk within a first passage contingent claims model. We price total return swaps on property indices with different levels of default risk. We develop this model under same assumptions as Bjork and Clapham (Journal of Housing Economics 11:418–432, 2002) and find that total return swap price is no longer zero. Total return swap payer must charge a spread over the market interest rate that compensates him for the exposure to this additional risk. Based on commercial property indices in the UK, we observe that computed spreads are much lower than a sample of quotes obtained from one of the traders in the market.