Managing bubbles in the Korean real estate market: A real options framework

Abstract

The aimof this paper is to propose a real options framework tomeasure andmanage bubbles in the Korean real estate market. The proposed framework carefully defines and utilizes the unique leasing mechanism in Korea, called the Jeonse system, a tentative contract for one or two years with a large amount of deposit, to represent the value of residence. Furthermore, the proposed framework applies the volatility with heteroscedasticity to improve the numerical accuracy in comparison to the traditional real options valuation model. The results of the model ultimately suggest the investment strategy that takes into account the measured bubbles in the market. Specifically, given that the Korean real estate market could be regarded as an American option, the investment strategy with early exercise completely eliminates the existing arbitrage opportunities in both long and short positions. In this context, the investment decisions based on the results of the proposed framework are expected to encourage the reflection of bubble-related information in the market, which eventually reduces the formation of bubbles via market mechanism for arbitrage elimination. In conclusion, the bubble-related information obtained from the model is expected to contribute to the stability of the real estate market by reducing the volatility of house price and quick price adjustment to new information.