Week 5: Appraisal smoothing and price discovery

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Week 5Appraisal smoothing and price discovery
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1. Introduction

• Smoothing means historical information in current
  valuations.
• Price discovery between markets means historical
  information from one market is in prices in
  another.

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2. Appraisal smoothing assumptions

• Fundamental prices are unobserved
• Fundamental prices follow a random walk
• Observed and fundamental prices differ

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3. The optimum updating rule

• The optimum updating rule is
• where

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4. Estimation of the smoothing factor (K)

• If V follows a first order autoregressive
  process
• but
• so

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5. Smoothing at the individual property level

• For an individual property
• So
• K close to 1 too much weight on error
• K close to 0 too little on market change

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6. Smoothing in a property index

• In an index is diversified
• The optimal choice of K for an individual
  property is not the same as for an index.
• But indices are constructed from individual
  valuations undertaken for other purposes.
• Appraisal indices are smoothed.

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7. Price discovery I

• Price discovery is the process by which asset
  prices are formed.
• The opinions of market participants are
  aggregated into a single statistic market price.
• Direct and indirect property have a common
  component of value, but separate markets.

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8. Price discovery II

• Price discovery of the common component may occur
  first in one market and then be transmitted to
  the other market.
• The indirect market is more liquid, so expect
  price discovery to be quicker.

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9. Defining price discovery between markets

• Evidence of the statistical significance of past
  returns in one market in forecasting future
  returns in the other market.
• Need to desmooth the appraisal series and then
  test for the significance of past returns from
  the other market.

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10. Granger causality

• Test significance of past returns in one market
  in explaining returns in another
• Restricted model
• Unrestricted model
• Test both ways.

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11. Empirical results

• The general finding is that price discovery exist
  from the indirect to the direct market.
• Can this be exploited to forecast the direct
  market?
• Can the information in smoothing and price
  discovery be used for commercial advantage?
• Would costs cancel profits?
• Can action be taken in time?