SSRN Id1304602

UNIVERSITY OF EDINBURGH
MANAGEMENT SCHOOL
Hedging the Art Market: Creating Art Derivatives
by
Olivia Ralevski
Dissertation Presented for
the Degree of Master of Business Administration
2008
©Olivia Ralevski, 2008

Hedging the Art Market: Creating Art Derivatives Abstract
Abstract
A number of inefficiencies in the art market stress the fact that art remains a highly risky
investment. The art market is characterized by high illiquidity, inefficient market
information, high transaction costs, long transaction time and the absence of a hedging
mechanism. Therefore, unlike investments in other sectors, investors cannot calculate the
risk and return profile of art. More importantly, this currently makes it very difficult to
hedge, or protect against possible losses. Applying a hedging strategy to art will bring
the liquidity and regulation needed as well as stimulate future investment.
This dissertation will explore the opportunity for derivative products in art. In order to
create a ‘true’ hedge for art, derivatives with art as the ‘underlying’ should be developed.
I propose a model for a total return art swap which will allow investors to protect
themselves against movements in the art market. The need for tradable art indexes,
which are crucial for the successful creation of art derivatives, will also be discussed.
These aims will be achieved by exploring the recent emergence of property derivatives
due to its marked resemblance as an asset class.
In my study, I find that art derivatives have enormous market potential. They can bring
liquidity and efficiency to the market and provide numerous benefits to investors. These
potential benefits include removing the high transaction costs associated with art
purchases, limited start-up cost with a low financial commitment, customized
transactions and quick executions. A discussion surrounding derivatives is particularly
relevant amid the recent financial turmoil since investors are reminded of the advantages
of hedging. Art derivatives can revolutionize the art market by offering a simpler and
easier way to manage the risk and return of art. My hope is that this paper will begin a
debate among the worlds of art and finance on the advantages of creating art derivatives.
Olivia Ralevski ii
Hedging the Art Market: Creating Art Derivatives Table of Contents
Table of Contents
Abstract ii
Table of Contents iii

List of Figures iv
About the Author v
Chapter 1 – Introduction 1
1.1 Background 1
1.2 Scope of Work 1
Chapter 2 - Art as an Investment Vehicle 4
2.1 The First Art Investment Fund 6

2.2 Modern Day Art Investment Funds 7
2.3 The Low Success Rate of Art Investment Funds 10
2.4 Hedging Using Derivatives 11
2.5 Art Hedge Funds 13
Chapter 3 - The Creation of Art Derivatives 16
3.1 The Success of Property Derivatives 16

3.2 Credit Derivatives: The Art Credit Default Swap 22
3.3 A Proposed Model for a 2-Year Total Return Art Swap 23
Chapter 4 - Art Indexes 29
4.1 Using Property Indexes as a Model 33

4.2 Improving Art Indexes 37
Chapter 5 – Conclusion 39
Appendix 43
Appendix 1: Commercial Proposition for an Art Derivatives Market 44

Appendix 2: US Investor Survey on Real Estate Derivatives Result –
Conducted by the MIT Centre for Real Estate 45
Bibliography 51
Olivia Ralevski iii

Hedging the Art Market: Creating Art Derivatives List of Figures
List of Figures
Figure 1: Francis Bacon (1909-1992) Triptych (1976) Oil on Canvas 4
Figure 2: Mei and Moses Study (2005) Compound Annual Returns and
Correlation Data for Art, S&P 500, UST 10 yr, UST Bills, and
Gold for the Last Fifty Years 6
Figure 3: Hermann-Paul Cartoon of La Peau de l’Ours in the French

Newspaper Gil Blas, 1914 7
Figure 4: Monthly Annualized Turnover Rates of Single Family Properties

versus Turnover of Stocks in the US in 2006 17
Figure 5: Credit Derivatives Market between 1996 and today 22
Figure 6: Proposed Model for a 2-Year Total Return Art Swap 24
Figure 7: Édouard Manet (1832-1883) Le déjeuner sur l’herbe (1862-63) 26

Oil on Canvas
Figure 8: Sample Index of Modern European Painting from 1975 to 1999

Created by Art Market Research 30
Figure 9: Eric Teitelbaum Cartoon in The New Yorker, 1990 42
Olivia Ralevski iv
Hedging the Art Market: Creating Art Derivatives About the Author
About the Author
Olivia Ralevski recently completed her MBA at the University of Edinburgh. She has
also received her B.A. in Art History from McGill University in Montréal, Canada and
her M.A. in Art History from Concordia University in Montréal. Her M.A. dissertation,
“North American Art and Modern Forms of Investment”, focused on the success of art in
investment portfolios and art-investment funds. Over the years, Olivia has gained
extensive experience working in leading galleries and museums in the United States and
Canada. She currently resides in Edinburgh.
Olivia Ralevski v
Hedging the Art Market: Creating Art Derivatives Introduction
Chapter 1 - Introduction
1.1 Background
Buyers at auction houses are resisting fears of the sub-prime crisis and credit
crunch with sales in the art market continuing to move beyond expectations.1 Recently,
economists such as Mei and Moses (2005) and Campbell (2005) have touted art’s ability
to provide diversification benefits due to its low correlation with the other more
traditional investments such as stocks, bonds, equity and cash. This belief led ultimately
to the re-emergence of the modern day art investment fund in 2001 and the notion that
there was “speculative money to be made from the art market”.2 Chapter two traces the
idea of art as an investment vehicle from the beginning of the twentieth century to the
present day. In 2007, a major shift occurred in art investment funds with the introduction
of the first art hedge fund. The Art Trading Fund was the first art investment fund to
offer a hedge against the art market by using equity derivatives.
1.2 Scope of Work
The Art Trading Fund has therefore become the first step in creating a hedge for
art. However, a ‘true’ hedge for art, would require the creation of a derivative with art as
the ‘underlying’. Applying a hedging strategy to art will bring the liquidity and
regulation needed as well as stimulate future investment. In chapter three, I propose a
total return art swap, which will allow investors to protect themselves against movements
in the art market. In doing so, I make comparisons with both the property and credit
derivatives markets. The property derivatives market is a very useful comparison
because, like art, it is a heterogeneous commodity in a market that is highly illiquid and
1
Financial Times, “Monet fetches record $80.5m,” June 24, 2008.
2
Ralevski, O. “North American Art and Modern Forms of Investment,” December 2007, pp. 57.
Olivia Ralevski 1
inefficient. I have therefore modeled the art derivative on the property derivatives
market. The credit derivatives market provides insight on the opportunity for derivative
products in art through the proposed introduction of the art credit default swap.
Examining the property and credit derivatives markets has two important implications.
First, it allows us to recognize the many parallels that exist between the property and art
asset classes. It also illustrates a second instance where derivatives could be used to
reduce risk in the art market. The prospect of creating art derivatives is therefore very
realistic.
The successful creation of art derivatives depends on the development of reliable
art indexes as discussed in chapter four. A number of art indexes have been developed
however, trading is still not possible for three major reasons. Firstly, there is a lack of
people who are interested or willing to trade on this type of index. Secondly, art indexes
use weak methodologies to provide an accurate description of art’s performance.
Thirdly, they suffer from a number of fundamental problems, specifically that all of the
art indexes are based on auction sales and not private sales. Auction prices that are
available do not take into consideration transaction costs such as tax, insurance, handling,
legal and auction fees which can vary greatly across works of art. Furthermore, art
indexes cannot be updated frequently to reflect current trends in the market due to their
low turnover rate. Suggestions for improvement are also offered including the creation of
sub-indices, choosing a suitable index methodology, and promoting information
disclosure among dealers and collectors. The development of property indexes is used as
a comparison because it is the most comparable index.
Olivia Ralevski 2
Finally, chapter five examines what the future holds for art derivatives. There is
enormous market potential for this new product and it should be brought to the attention
of the commercial market for future development. A commercial proposition for an art
derivatives market is therefore presented. In my study, I find that art derivatives can
bring liquidity and efficiency to the market and provide numerous benefits to investors.
These potential benefits include removing the high transaction costs associated with art
purchases, limited start-up cost with a low financial commitment, customized
transactions and quick executions. I conclude this chapter by providing suggestions for
the future development of a viable art derivatives market by focusing upon its two main
obstacles: the improvement of market liquidity and the development of reliable art
indexes.
Olivia Ralevski 3
Hedging the Art Market: Creating Art Derivatives Art as an Investment Vehicle
Chapter 2 - Art as an Investment Vehicle
The art market is currently booming with auction houses claiming record sales.
Sotheby’s reported its biggest sale of contemporary works on Wednesday June 25th 2008,
worth $362m. Francis Bacon’s Triptych (1976) (Figure 1), sold for $86m, surpassing its
estimated price of $70m. This was the highest price ever paid for a contemporary work at
auction.3 That same week, the contemporary art sale at Christie’s generated $348m. The
combined sales of the two main auction houses over a 2-week period in the summer
totaled nearly $2bn, 25 percent more than in the same period last year.
Figure 1: Francis Bacon (1909-1992) Triptych (1976)

Oil on Canvas
Art is in high demand because it is a unique commodity that is in limited supply.
Most highly regarded works are in museums or private collections. This creates a market
composed of heterogeneous products that is highly illiquid, inefficient and unpredictable.
Art also acts as a defensive asset working well during economic slowdowns like the one
we are currently experiencing. A study published in 2001 by professors Jianping Mei and
Michael Moses of New York University’s Stern School of Business looked at how four
3
Financial Times Wealth Issue, “Art Market Still Thriving 2008,” Summer 2008, Issue 2, pp. 8.
Olivia Ralevski 4
recent wars and twenty-seven recessions have affected the prices of art.4 Their database
included 5,000 auction prices for paintings sold in London and New York between 1950
and 2001 as well as paintings resold at Christie’s or Sotheby’s from 1875 to 1950. They
concluded, “During the armed conflicts of lengthy duration of the last century, art
indexes outperformed major stock indexes”.5 While in the long term, stocks do
outperform art, during periods of war and recession art performs well. During both
World War I and II, the US and British stock markets plunged while art outperformed the
S&P during most of those years. Mei and Moses believe that art outperforms stocks
during these periods of uncertainty because they can cause the displacement and
disassemblement of art collections resulting in art of high value emerging onto the
market. Art is therefore one class of investments that seems to remain unaffected by the
credit crunch and sub-prime crisis.
Recent economic research has shown that art has strong investment potential
through its ability to provide diversification benefits to investment portfolios. For
example, in a 2005 study by Mei and Moses, art (which in this study consists of
paintings, drawings, watercolors and sculpture) outperformed stocks with a 13.00 percent
real return (which is adjusted for inflation) after one year from 2005 to 2006, while stocks
showed a real return of 10.88 percent (Figure 2). Furthermore, they demonstrate that
there is a negative correlation between art and traditional assets such as stocks, treasury
bills and gold suggesting that adding art for diversification purposes in an investment
portfolio is recommended. Investors have cashed in on these ideas and more recently this
4
Mei, J. & Moses, M. “Art as an Investment and the Underperformance of Masterpieces: Evidence from
1875-2000,” American Economic Review, May 2001, pp. 1-37.
5
Barker, G. “Give ‘Em Shelter,” Forbes, December 24, 2001.
Olivia Ralevski 5
has led to the re-appearance of purely speculative investment strategies such as the art
investment fund.
Figure 2: Mei and Moses Study (2005) Compound Annual Returns and
Correlation Data for Art, S&P 500, UST 10 yr, UST Bills, and
Gold for the Last Fifty Years
2.1 The First Art Investment Fund
The art investment fund originated in the early twentieth-century in France.
Known as La Peau de l’Ours, the French financier, André Level pooled money together
along with that of twelve other investors to purchase over a hundred Modern paintings
and drawings. A decade later, in 1914, these works, which included some famous
artworks by Picasso, Matisse and Van Gogh, were sold at an auction and the profits
(which by that time had quadrupled) were divided among the investors. Art was
therefore clearly used as an investment tool. A cartoon published that same year, in the
French newspaper, Gil Blas emphasizes art’s financial rather than aesthetic value (Figure
3). The translated caption describes a mother explaining to the gentlemen suitor seated
next to her that she does not have a dowry to give for her daughter. However, she does
have a beautiful collection of futurist works.6
6
Fitzgerald, M. C. “Making Modernism: Picasso and the Creation of the Market for Twentieth-Century
Art,” 1996, pp. 41.
Olivia Ralevski 6
Figure 3: Hermann-Paul Cartoon of La Peau de l’Ours

in Gil Blas, 1914
2.2 Modern Day Art Investment Funds
Art investment funds appeared again briefly in the 1970’s, including the famous
British Rail Pension Fund that gave investors returns of around 11.3 percent. The fund
purchased a variety of art pieces including Old Masters, Impressionists, Medieval art,
Chinese ceramics and African tribal art as well as books and manuscripts. The whole
collection was auctioned off between 1987 and 1999 but was then shut down by the
Internal Revenue Service who believed that a pension fund should not be involved in the
art business.7
The art investment fund boom however really began to take off in 2001 with
approximately 50 funds attempting to launch.8 Charles Saatchi, a famous UK art
collector and advertising tycoon brought back the notion that there was “speculative
7
Watson, P. “The Rise of the Modern Art Market: From Manet to Manhattan,” 1992, pp. 425.
8
Caslon Analytics, “Art fund note,” 2008.
Olivia Ralevski 7
money to be made from the art market”.9 At this time, an increase in high net worth
individuals (HNWI’s) and the booming art market created the high demand for art
investment funds to thrive. HNWI wealth is currently believed to be over $30 trillion and
increasing at a rate of 7 percent per year. It is also thought that $300 billion of this
wealth is used for art investment.10
These funds are created in the most part by independent investment firms, private
institutions and individuals. Money to purchase art is generated through targeting
wealthy individuals, university endowments and pension funds. Individuals should have
at least $5 million in investable assets and pay a minimum of $250,000 to invest. The
funds use this money to purchase works from various genres such as Old Masters,
Impressionists, Contemporary and Modern Art among others in order to benefit from
diversification. Funds are usually close-ended, meaning investors are locked in for the
entire term of the fund which depending on the fund can be anywhere from three to ten
years.
The discrete nature of these funds makes it difficult to assess their level of success
however some evidence suggests that only a small percentage are generating profit. To
date, only the Osian Art Fund and the Fine Art Funds have been successful. Neville Tuli,
chief advisor of the Osian Art Fund reported that they attracted $26 million of assets
under management in 2006 and are “doing well”.11 This fund invests in artworks by
major artists from India, Bangladesh, Pakistan, Nepal and Sri Lanka. The Fine Art Fund
I, which invests in Old Masters, Impressionists, Modern and Contemporary art is a 10-
year close-ended fund now closed to investors. It reported third year returns of 44
9
Ralevski, pp. 57.
10
Mamarbachi, R., Day, M., & Favato, G. “Art as an Alternative Investment Asset,” March 26, 2008, pp. 6.
11
Owen, C. “Indian Fine Art Fund Launched,” January 18, 2008.
Olivia Ralevski 8
percent with a holding period of 12.11 months. According to Philip Hoffman, the chief
executive, their strategy is to buy $1 or $2 million dollars of artworks per year and re-sell
these works after one year. This may be one reason for their success since most other
funds held works from 3 to 7 years before bringing them back to the market. The Fine
Art Fund II is on track to raise their target of $50 to $100 million as is their Chinese Art
Fund which will invest in traditional, Modern, and Contemporary Chinese Art covering
the last 500 years. They also have plans to expand their funds to include an Indian Fine
Art Fund and a Middle Eastern Fine Art Fund.12
The Indian art market has become extremely popular for art investment. The size
of the Indian art market has developed quickly with revenues increasing from $2 million
to $400 million over the last seven years.13 “The market for Indian art globally is still in
its emerging phase and the growth has been much slower compared to that of China. One
difference between the two has been that as against the Chinese art market where the
demand spurt came from European and American buyers, Indian art until now has largely
been bought by Indians living abroad,”14 says Philip Hoffman, in an interview with The
Economic Times. Indian art is also less expensive relative to the prices of Old Masters
and Impressionists.
Furthermore, in an interview with Jessica Knopp-Gwynne, United States Business
Head of Fine Art Wealth Management, an art investment consultancy company, she
highlighted that art investment funds are popping up frequently. Two new funds are
expected to launch in 2008 including the US based Meridian Emerging Art Markets
Fund. It will focus on Contemporary art from emerging markets throughout the world
12
The Fine Art Fund Group http://www.thefineartfund.com/home.asp
13
Sinha, V. “Hoffman raises $25 mn Indian Fine Art Fund,” The Economic Times, January 17, 2008.
14
Owen, “Indian Fine Art Fund Launched”.
Olivia Ralevski 9
including Africa, Asia, India, Latin America, the Middle East and Russia as well as
Western Contemporary art. The other fund is the first to be backed by a bank, Société
Générale.15 This fund will focus on 20th and 21st century works and is on target to reach
its goal of $50 million.
However, despite news that more funds are being developed, the high turnover
rate of funds raises concerns. Only twenty funds were reported in existence in 2007
down from fifty in 2001.16
2.3 The Low Success Rate of Art Investment Funds
There could be many reasons for the high art investment fund failure rate but the
main reasons lie within six inefficiencies of the art market not found in the more
traditional investment market.17 The first problem is the lack of transaction volume.
Unlike the equity market where transactions occur daily, half of the transactions in the art
market take place at auctions which are on set days usually six months apart. Second, the
art market is informationally inefficient. The entry of new information intermediaries has
increased the amount of information available to buyers and sellers but there is still no
reliable source of information available on the investment performance of art.
Inelastic supply, also known as the ‘museum factor’, is another problem. Most
museums have restrictions on the paintings they can sell from their collection. As a
result, some works are completely inelastic and do not appear on the market. A fourth
problem is low, or lack of, liquidity. Unlike stocks and bonds, art is not a commodity
15
International Fund Investment, “SGAM unveils plan to launch art fund,” July 4, 2007.
16
Ralevski, pp. 157-158 .
17
A more detailed description of the six inefficiencies of the art market can be found in:
Keller, T. & Groysberg, B. & Podolny, J. “Fernwood Art Investments: Leading in an Imperfect
Marketplace,” Harvard Business Review, September 24, 2004, pp. 4-5.
Olivia Ralevski 10
that is bought and sold on a daily basis. The art market also lacks price standardization
and transparency. There is no one accepted valuation methodology that dictates
transaction prices in the art market. Pricing is based on tight networks between dealers
and clients and is subject to intangible factors such as fashion and luck. As a result, the
market is therefore largely unregulated. The Securities and Exchange Board of India has
recently taken a stand on the matter asserting that art funds, which deal in public money,
should be registered.18 Finally, art transactions require very high transaction costs which
include purchase tax, insurance, handling, legal and agent fees (which often go above 5%
of the purchase price).
The number of inefficiencies in the art market stresses the fact that art remains a
highly risky investment. Unlike investments in other sectors, investors cannot calculate
the risk and return profile of art. More importantly, this makes it difficult to hedge, or
protect against possible losses. Applying a hedging strategy to art can bring the liquidity
and regulation needed as well as stimulate future investment.
2.4 Hedging Using Derivatives
Hedging techniques usually involve the use of financial instruments known as
derivatives. According to Alan Greenspan, former Chairman of the Board of Governors
of the US Federal Reserve, “by far the most significant event in finance during the past
decade has been the extraordinary development and expansion of financial derivatives.
These instruments enhance the ability to differentiate risk and allocate it to those
investors most able and willing to take it - a process that has undoubtedly improved
18
Vallikappen, S. “SEBI raps art funds,” Indian Art News, 2008.
Olivia Ralevski 11
national productivity growth and standards of living”.19 Derivatives are contracts that
obtain their value from the value of another asset referred to as the ‘underlying’. Two
types of derivatives exist: commodity and financial. A commodity derivative is when the
underlying is gold or wheat for example. A financial derivative is when the underlying is
a financial asset like currency. An investor, for example, can buy a derivative with wheat
as the underlying without having to purchase it.
Investors use derivative products to bet that the market will move against them so
they can win either way at a price. Modern day derivative contracts grew from the desire
of farmers who needed to protect themselves from price declines in their crops due to
natural disasters. Derivatives are based on indexes since the bets made on the index are
what generate returns. The indexes collect market information to provide an accurate
description of an asset’s performance.
There are four main types of derivative contracts: futures, forwards, options and
swaps. Futures are standardized contracts that give the buyer the opportunity to buy or
sell the underlying at a pre-determined price and at a specific date. Forward contracts are
similar except they can be customized to suit the user’s needs. Options give the buyer the
right to buy or sell the underlying at a pre-determined price in the future and swaps are a
contract between two parties to exchange cash flows.20 In the 1980’s, futures and
forwards began to dominate derivative trading and growth in swap and option activity
soon followed.21 Forwards and swaps are usually traded through a dealer, and thus,
known as over-the-counter derivatives (OTC). Options and futures are usually traded on
19
Rediff, “All you wanted to know about derivatives,” April 19, 2005.
20
Investopedia, “The difference between options and futures”.
21
BBC News, “Derivatives-a simple guide,” February 12, 2003.
Olivia Ralevski 12
a formal exchange such as the NYSE or the TSX and are considered exchange-traded
derivatives (ETD).
Derivatives are very attractive to investors since they are highly liquid and
cheaper to purchase than the asset itself. They can be bought or sold easily since you do
not have to own or deal with the actual asset. Due to their flexibility, various types of
investors, such as fund managers and pension funds use derivatives. However,
derivatives have also earned a bad reputation. The famous collapse in 1995 of one of the
oldest banks in London, Barings Bank, was due to the unauthorized investments in
futures contracts of one of its employees, Nick Leeson. Mr. Leeson lost $1.4 billion
forcing the bank to file for bankruptcy. Derivatives also played a role in the demise of
Enron, the American energy company and the termination of Long-Term Capital
Management, the US hedge fund that plunged the financial markets into crisis in the late
1990’s. Derivatives are complicated and especially risky if markets go the wrong way.
Usually the market will shift slightly but if it does move considerably big losses can
result.
Despite these incidents and amid the current turmoil in the global financial
markets, derivatives’ trading continues to grow at a steady rate. Last year, equity
derivatives were used by an art investment fund to hedge against a fall in the art market.
The use of derivatives in conjunction with art was previously unheard of.
2.5 Art Hedge Funds
In 2007, the first art hedge fund was launched. The Art Trading Fund is the first
art investment fund to offer a hedge. The fund was created by Chris Carlson and Justin
Williams of AIA Artistic Investment Advisory, a money management company based in
Olivia Ralevski 13
London. The Art Trading Fund buys and sells art similar to a traditional art investment
fund but also uses derivatives in the form of options to hedge against a fall in the market.
The fund purchases equities in companies like Sotheby’s that are highly correlated with
the art market. Other equities such as Richemont, a Swiss leading luxury goods group,
and economic growth and disposable income at the 90th percentile in the leading art
buying countries are included in the basket of hedges. When combined, these securities
have had a 96 percent correlation with the art market over the past 30 years. Therefore, if
the market falls, the value of these securities will also fall and they will make a profit.22
The fund has already attracted $40 million from investors and is structured as a
three-year, regulated and close-ended fund. There is a $200,000 minimum investment
required as well as a 2% flat annual management fee and a 20% performance fee on
return over Libor. The fund is also structured as a Protected Cell Company. This is a
company that has been divided into separate portions known as cells. Each member’s
capital is protected from other members and has its own individual portion of the
company’s overall share capital with no third party access.23
Works by Contemporary artists with a proven track record of 5 years are
purchased every six months from the artist directly. “It’s a guarantee for them. Twice a
year they have a liquidity event. This is very uncommon for an artist. They know they
are going to be paid on time. Galleries usually take a long time to pay them,” says
Williams in an interview with the New York Sun.24 Charles Saatchi, the famous UK art
22
Johnson, S. “Hedge fund sees art as exotic asset class,” The Financial Times, June 15, 2007.
23
New Star Asset Management “Glossary”.
24
Taylor, K. “Seeking a hedge for art”, The New York Sun, August 13, 2007.
Olivia Ralevski 14
collector will advise the fund on its contemporary art purchases and in return will receive
a percentage of the profit.25
The fund expects that investors will receive a thirty percent return per year. Such
high returns they say is a result of an increase in mid market art purchases and quick
trading (the holding period is just over 5 months) which make it safer for investors than a
traditional art fund. “All our trades have at least three exit opportunities attached, says
Williams, and we go for the exit with the quickest and best margin of return”.26
However, some have argued that the Art Trading Fund does not offer a real
hedge. Former corporate raider and now New York art dealer Asher Edelman believes
that stocks in companies like Sotheby’s are not perfectly correlated with the art market.
Sotheby’s stock could drop for reasons other than an art market decline such as a fall in
the stock market.27 The Art Trading Fund is therefore only the first step in creating a
hedge for art. In order to create a ‘true’ hedge for art, derivatives with art as the
underlying should be developed.
25
Burroughes, T. “Advertising Tycoon Charles Saatchi to Advise Art Hedge Fund,” Forbes, May 23, 2008.
26
Greekshares, “The art of investing in art,” 2008.
27
Taylor, “Seeking a hedge for art”.
Olivia Ralevski 15
Hedging the Art Market: Creating Art Derivatives The Creation of Art Derivatives
Chapter 3 - The Creation of Art Derivatives
In order to discuss how art derivative contracts could be designed, it is important
to first look at the latest asset class to become a derivative. Property was one of the last
major assets in the West without a derivatives market despite the fact that in many
countries, residential and commercial property combined make up more than half of the
national wealth.28 For the purpose of this paper, I will define property as commercial and
residential. I will also only focus on the United Kingdom, which is leading the way in
property derivatives.
What is particularly interesting about property is that for years the idea of creating
property derivatives was considered an unlikely task. As one writer remarked “if you
turn the clock back to 1981, and you ask people if they used interest rate derivatives,
they’d say no, and that was the year the first interest rate swap was done. Now it's a
trillion dollar market. I expect a similar sort of growth in terms of the property market”.29
Similarly, parallels have been drawn to the growth and development of the credit
derivatives market. The credit default swap derivative, for example, has grown from
approximately $180 billion in 1997 to $5 trillion in 2004.30 Both of these markets will be
examined and used to speculate and provide insight on the creation of art derivatives.
3.1 The Success of Property Derivatives
Property derivatives are financial contracts that obtain their value from the value
of property. Property is a highly risky investment and homeowners have no way of
28
Case Jr., K. E. & Shiller, R. J. & Weiss, A. N. “Index-Based Futures and Options Markets in Real
Estate,” Journal of Portfolio Management, Winter 1993, Vol. 19, Issue 2, pp. 1.
29
Philips, M.K. “Property derivatives on the rise,” Global Investor, May 2004, No. 172, pp. 63-4.
30
Clayton, J. “Commercial real estate derivatives: the developing U.S. market,” Entrepreneur.com, Fall
2007.
Olivia Ralevski 16
protecting themselves.31 These derivatives are a cheaper, easier, and faster way to hedge
property risks without buying property. Investors might hedge property for many
reasons. For example, they may think interest rates may go up or rent prices may go
down.32
Property is very different from other asset classes in much the same way that art
is. It is difficult to value, trade and track its price development. Standardization was
needed to make the real estate market more liquid and efficient. Property is considered
heterogeneous and is usually held for long periods of time. Turnover is therefore much
lower than that of other asset classes. Figure 4 compares the monthly turnover rate of
properties to that of stocks during 2006. When compared to stocks, property is about
one-tenth. Hedging property risks is therefore more difficult than hedging stocks and
commodities.
Figure 4: Monthly Annualized Turnover Rates of Single Family

Properties versus Turnover of Stocks in the US in 2006
31
Ergungor, O.E. “Home Price Derivatives,” February 15, 2007.
32
Euro Hypo AG Investment Banking, “Property derivatives: A window on the future?” September 2007,
Issue 13, pp. 3.
Olivia Ralevski 17
Discussions surrounding property derivatives began in the early 1990’s but their
debut on the London Futures and Options Exchange (London FOX) in 1991 ended in
scandal. False trades were executed to create the impression of higher transaction
volumes to increase the liquidity of the market. However, property derivatives re-
appeared successfully in January 2005 in the UK with the first property swap derivative.
Swaps currently lead the way in property derivatives trading. It is believed that options
will gain increasing importance.
Pension funds, hedge funds and investment banks are among the most common
users of property derivatives. Commercial derivative products are mainly used by pension
funds and hedge funds that have holdings in commercial property and are looking to
hedge their portfolios whereas residential derivative products are usually used by
homeowners. Terms are specified upfront and contracts last for two to three years. An
investment bank would buy a license from an index in order to execute property
derivative trades. The bank can execute the trade directly, making money on the spread
between the prices agreed by the two parties. The bank could also execute the trade via
an ‘inter-dealer’ broker, a firm that specializes in executing derivative trades.33 Eleven
banks are now currently licensed to use the UK Investment Property Databank Indexes
(IPD indexes) to sell and develop property derivatives.
Commercial property derivatives are most commonly structured as Total Return
Swaps (TRS). They are usually referenced to the UK All Property Index which is just
one index included in the UK Investment Property Databank Indexes. Total Return
33
Clayton, “Commercial real estate derivatives: the developing U.S. market”.
Olivia Ralevski 18
Swaps are simply swaps that are ‘total return’ meaning the return is based on the capital,
plus any interest on dividend payments on the property.34
How a commercial property swap works will be illustrated in the following
example. A pension fund with a large real estate portfolio is concerned about the
weakening property market and believes it is overexposed. It is interested in hedging the
portfolio’s risk but does not want to sell it since it believes that it may do well in the long
term. Moreover, there is a high cost associated with selling the property and it would
take a significant amount of time to close the transaction. Investing in derivatives will
allow them to keep the portfolio. The pension fund enters into a swap agreement with
another party, pension fund B, who would like to invest in the property market because
they need exposure to that market for diversification purposes. Pension fund A therefore
agrees to pay pension fund B the ‘total return’ based on the performance of the IPD All
Property Index in return for a fixed interest (could be connected to an inter bank rate such
as the Euribor or the Libor). If the property market weakens, pension fund A can
stabilize the returns of its portfolio with the additional and constant cash flow while only
paying pension fund B a low property return, thereby reducing its risk. Pension fund B
on the other hand also minimized its risk by gaining exposure to the market. In essence,
both parties reduced their risk by swapping cash flows and either gaining or reducing
their exposure to the market.
The residential property sector is about ten times the size of the commercial sector
in value.35 Residential property derivatives are usually structured as swaps or options and
are linked to the most popular UK residential index, the Halifax House Price Index.
34
Sedgwick, C. & Clayton-Stead, M. “Property Derivatives: The last frontier,” 2008.
35
Roche, J. “Property futures and securitization-the way ahead,” 1995, pp. 8.
Olivia Ralevski 19
How a residential property option works will be illustrated in the following example. A
London homeowner is concerned with the current US and some European housing
markets and is interested in hedging the risks of his residential property. The homeowner
therefore buys a property option which is linked to the Halifax House Price Index. He
would use this option to bet that the housing prices would move against him (decrease) so
that he could profit either way. If UK housing prices decreased by the time the option
expired, he could sell the option and make a profit.
Ironically, despite their size in value, residential derivatives lack institutional
investment and are not as robust of a market. This may be due to less reputable indexes.
To date, the total amount traded on the IPD Indexes in 2008 is 17 billion pounds whereas
only 2 billion pounds of residential derivatives were traded on the Halifax House Price
Index over the last seven years.36
Overall, the UK property derivatives market has been performing very well,
growing particularly in the last three years. There are three main reasons for its success.
The first is the fast spread of the property derivatives market to other countries such as
Australia and Japan. 37 The sub prime mortgage collapse has also increased the incentive
to invest in property derivatives since investors are reminded of the advantages of
hedging. Lastly, there has been an increase in investors with the addition of new players
such as hedge funds. Investors have finally realized the benefits of using property
derivatives. These benefits include no taxes, agent or surveyor fees, they are easier to
purchase than actual property, you can act on a position quickly since you can buy or sell
36
Fenlon, A. “UK property derivatives-a focus on residential,” 2007.
37
De Teran, A. “The slow and steady journey to success – Property derivatives have been tracking a slow,
circuitous path toward the investment mainstream for almost 20 years. But with property market risk
firmly on investors’ minds, they may finally be,” The Banker Online, December 1, 2007.
Olivia Ralevski 20
immediately and you can still gain the portfolio diversification benefits of the direct
property market. Using property derivative products can therefore reduce many of the
disadvantages of direct property investment.
There are however some who argue that property derivatives will be used for
“leverage on so-called ‘exotic debt structures’ piling additional debt on instruments that
could crash”.38 Derivative trading should be done responsibly and by qualified and
knowledgeable investors. There is a definite sense that there is a knowledge gap between
traditional property investors and the Wall Street derivatives world.39 Much of the bad
press property derivatives receive is due to the mishaps of uneducated investors.
Undoubtedly, there is still room for improvement but the property derivatives market has
come a long way. The increased activity in the past three years suggests a growing
awareness and acceptance of property derivatives. Many of the problems it faces have
been addressed such as increasing liquidity and developing more credible indexes. These
have allowed the property derivatives market to attain an efficient size and structure.
Much can therefore be learned from the success of the property derivatives market and
can be used to speculate on the creation of art derivatives. A very important recent
theoretical development in the credit derivatives market will also provide insight on the
opportunity for derivative products in art.
38
Jacobius, A. “Property Derivatives are latest buzz,” Pensions and Investments Online, Dec. 25, 2006.
39
Clayton, “Commercial real estate derivatives: the developing U.S. market”.
Olivia Ralevski 21
3.2 Credit Derivatives: The Art Credit Default Swap
Figure 5: Credit Derivatives Market between 1996 and Today
The credit derivatives market is among the fastest growing financial product.
Figure 5 shows that it has increased in size by more than 11,000 percent from 1996
(when the credit derivatives market began to take off) to 2008.40 The majority of credit
derivatives are structured as swaps known as credit default swaps (CDS). They work like
swap contracts where party A buys protection from party B, who has an appetite for risk.
Party A needs credit protection in case party C, known as the reference entity, defaults on
the loan it entered in with party A. The swap agreement therefore consists of party A
paying a periodic fee to party B and in return receiving a payoff only if the reference
entity defaults.
Campbell and Wiehenkamp (2008) apply the credit default swap model to the art
market and propose an art credit default swap (ACDS). This would be used to increase
efficiency and reduce risk when lending art as collateral. With the increase in high net-
worth individuals, more people have their money tied up in art. It has therefore become
40
Wiehenkamp, C. & Campbell, R. “Art Credit Default Swap Pricing,” Working Paper Limburg Institute
of Financial Economics, Erasmus University Rotterdam, April 1, 2008, pp. 2.
Olivia Ralevski 22
increasingly important for collectors for example, to use art as collateral when they are in
need of cash.41 The swap works as follows: a bank, party A, provides the reference
entity, C, an art collector with an art-backed loan. The bank therefore seeks protection
and enters into an art credit default swap with party B, who is an opportunistic player,
like an art investment fund or an art hedge fund.
Examining the property and credit derivatives markets has therefore had two
important implications. First, it allowed us to recognize the many parallels that exist
between the property and art asset classes. It also illustrated a second instance where
derivatives could be used to reduce risk in the art market. The prospect of creating art
derivatives is therefore very realistic.
3.3 A Proposed Model for a 2-Year Total Art Return Swap
A proposed model for an art derivative could be a total return art swap. How a
total art return swap works will be illustrated in the following example. An art hedge
fund like the Art Trading Fund is concerned that the current global economic situation
will cause art prices to fall and is interested in reducing its risk. However, the fund does
not want to sell any artworks since it believes that it may do well in the long term. There
are also high costs associated with selling the artworks and it would take a significant
amount of time to close the transaction. Investing in derivatives with art as the
underlying will allow them to keep the artworks and reduce their risk.
The art hedge fund enters into a 2-year total return swap agreement with a more
opportunistic player, another hedge fund who is interested in gaining exposure to the art
market to speculate on short-term changes in the art index. The art hedge fund agrees to
41
Ibid., pp. 1.
Olivia Ralevski 23
pay the hedge fund the ‘total return’ based on the performance of the Mei/Moses Fine Art
Index during a two-year period.42 In return, the hedge fund pays the art hedge fund a
fixed interest of 2% + LIBOR over 2 years. If the art market weakens the art hedge fund
can stabilize its returns with the added income while only paying the hedge fund a low
return on the index. The hedge fund on the other hand also reduces its risk by gaining
exposure to the market. The derivative is illustrated in Figure 6.
Pays Total Return based

on the Performance of the
Mei-Moses Fine Art Index
PARTY A for 2 years PARTY B
Art Hedge Fund Hedge Fund
Pays Fixed Interest Rate

of 2% + LIBOR for 2
years
Figure 6: Proposed Model for a 2-Year Total Return Art Swap
Art hedge funds are perfect candidates for using art derivatives. These derivatives
would also incentivize other hedge funds as well as pension funds and investment banks
to invest in art by offering a way to hedge the risk of including art in their portfolio for
diversification purposes. Investors might hedge art for many reasons, for instance they
many think interest rates may go up or art prices may go down. In addition to protecting
investors from movements in the art market, art derivatives are cheaper and easier to
purchase than the asset itself. They are highly liquid since you can buy or sell
immediately and there are no transaction costs (such as tax, insurance, handling, legal and
42
The Mei/Moses Fine Art Index is considered the most reputable art index to date. The index covers four
categories of paintings: Old Masters and 19th century painting, Impressionist and Modern paintings,
American paintings before 1950, and Postwar and Contemporary paintings. There is no trading on the
index but Mr. Moses, one of the creators of the index believes that people will eventually be able to trade
derivatives on the index.
Olivia Ralevski 24
auction fees) reducing many of the disadvantages of direct art investment. Therefore, as
a result, many of the inefficiencies of the art market will improve such as liquidity, price
standardization and regulation.
Investing in art derivatives is also much more attractive to investors than other
assets from a behavioral finance perspective. The ‘affect heuristic’, which was developed
by Paul Slovic and colleagues attempts to explain how people assess risks. They argue
that people base their decisions primarily on feelings and intuition rather than hard cold
facts or calculations.43 An investor would be less likely to invest in a stock based on
“utilitarian” characteristics of risk and expected return than “value expressive”
characteristics that convey our wealth, status, beliefs and taste. Investing in an art
derivative rather than an equity derivative is therefore much more attractive since art has
much more “value expressive” characteristics associated with it than a stock. People
have purchased art for hundreds of years not only for aesthetic pleasure and decorative
purposes but also specifically for the purposes of demonstrating their religious morality
or social prestige.
Art has also long been associated with stories and legends, which greatly increase
its investment potential. For example, the French artist Édouard Manet was one of the
artists associated with the late 19th century Impressionist art movement. His most famous
work Le déjeuner sur l'herbe (1862-63) (The luncheon on the grass) (Figure 7), inspired
controversy when it was first exhibited at the Salon des Réfus (Salon of the rejected) in
1863. The Salon des Réfus was created by Emperor Napoleon III in response to the Paris
Salon’s rejection of over 4,000 paintings. The painting features two fully dressed men
43
Lucey, B. M. & Dowling, M. M. “The Role of Feelings in Investor Decision-Making,” Journal of
Economic Surveys, April 2005, Vol. 19, No. 2, pp. 226.
Olivia Ralevski 25
and a nude female figure having a picnic in a rural setting. The men are believed to be
Manet’s brother Gustave and his future brother in law Ferdinand Leenhoff. The female is
also thought to be Manet’s model Victorine Meurent, however, the true identities of the
models are not known. The meaning of the painting as well as the title remains a
mystery. The painting was considered an attack on the propriety of the time and remains
an enigmatic topic among art historians resisting singular interpretations.44 Stories such
as this one are responsible for adding depth and emotion to these inanimate objects.
Figure 7: Édouard Manet (1832-1883) Le déjeuner sur l'herbe (1862-63)
The feelings we derive from art are also a result of the ‘creative process’. Unlike
stocks and other asset classes, art does not generate future cash flows but instead obtains
its value from the intellectual creativity associated with it. In fact, objects like art and
other intangible assets presently fall outside of the scope of current UK and US
definitions of an asset. The UK definition states that “assets are rights or other access to
44
Tucher, P. “Manet’s Le Déjeuner sur l'herbe,” 1998, pp. 5-6.
Olivia Ralevski 26
future economic benefits controlled by an entity as a result of past transactions or
events”. The US defines assets as “probable future economic benefits obtained or
controlled by a particular entity as a result of past transactions or events”.45 Defining art
as an asset based upon ‘future economic benefits’ negates its true nature.
However, behavioral finance theorists may also argue that investing in art
derivatives may be difficult due to another finding. A phenomenon known as “herding”
occurs when speculators trade not according to market fundamentals but by observing
where others invest.46 This topic is of particular importance due to the number of
economic crises that have occurred over the past two decades. During these times,
investors are more likely to imitate the actions of other investors who they believe have
more reliable information about the market than they do. Two other factors have been
identified which drive herding behavior in financial markets. Investors are likely to
display herding behavior to avoid straying too far away from others. They are also less
likely to avoid being dismissed from their job for being wrong and in a group rather than
wrong and alone.47 For an art swap to occur, there has to be two parties, each with a
different view of the market, some believing they should invest while others thinking
they should exit the market. A financial crisis might cause investors to all pull out at the
same time due to the herding phenomenon making it difficult to find an investor on the
other side that is willing to enter the swap the agreement.
While this may be one potential problem for art derivatives, it is a problem for
45
Tollington, T. & Liu, J. “When is an asset not an asset?” Management Decision, 1998, Vol. 36, No. 5,
pp. 349.
46
Weiner, R. J. “Do Birds of a Feather Flock Together? Speculator Herding in Derivative Markets,”
Working Paper, George Washington University, Department of International Business, September 2004,
pp. 3.
47
Persaud, A. “Sending the Herd off the Cliff Edge: The disturbing interaction between herding and
market-sensitive risk management practices,” World Economics, 2000, Vol. 1, No. 4, pp. 15-26.
Olivia Ralevski 27
derivatives in general. There is however a greater concern. The indexes upon which art
indexes are based are not available for trading.
Olivia Ralevski 28
Hedging the Art Market: Creating Art Derivatives Art Indexes
Chapter 4 - Art Indexes
A number of art indexes have been created in recent years such as the
Zurich/AMR Art & Antiques Index, the Art Sales Index, Artefact, and Askart. The three
most popular indexes are the Mei/Moses Fine Art Index, Artprice and Art Market
Research. These indexes are currently being used by investors to provide them with an
idea of how a particular genre of art has performed over time, against other genres or
other assets such as stocks, treasury bills and gold. For example, an investor can
purchase an index report from Art Market Research on the performance of Modern
European Painting from 1975 to 1999. A sample index from Art Market Research
(Figure 8) shows the price of Modern European painting reaching its highest levels
(almost reaching $10,000 in 1990) during the late 1980’s and early 1990’s. Trading on
the art index however is still not possible and there are three main reasons for this.
Firstly, there is a lack of people who are interested or willing to trade on this type of
index. Art indexes also use weak methodologies to provide an accurate description of
art’s performance and suffer from a number of fundamental problems.
Olivia Ralevski 29
Figure 8: Sample Index of Modern European Painting from

1975 to 1999 Created by Art Market Research
Some negative attitudes also exist towards using art in this manner. Some believe
that it will encourage people to separate art from meaning and bring about the
commoditization of art. Justin Williams, one of the founders of the Art Trading Fund for
example remarked, “I love the beautiful, sophisticated things in life, but for me art is just
a commodity, it’s a cold thing. I have collected well, but I see art as a P&L (profit and
loss account) on the wall”.48 The complete lack of personal involvement with art however
will not occur since one cannot replace the physical sale or purchase of art. This is very
similar to the argument that the Internet will replace the book. Reading a book on the
Internet cannot compare with the warm, personal experience of cuddling up with a good
book. People will continue to purchase art to hang on their walls to enjoy. In fact, the
use of art derivatives decreases the risks associated with purchasing artworks. Moreover,
much in the same way the property derivatives market developed along with the existing
48
Johnson, “Hedge fund sees art as exotic asset class”.
Olivia Ralevski 30
real estate market, the art derivatives market will develop alongside the existing art
market adding further depth and complexity.49 Innovative products do however take time
for people to accept and trading on the indexes will be a slow and lengthy process. Those
who are willing to invest are probably waiting for an increase in liquidity. Unfortunately,
this is a vicious cycle since an increase in trading will not occur until there are more
investors.
Another reason for the inability to trade on art indexes is their poor construction.
The Mei/Moses Fine Art Index uses repeat-sales regression and Artprice and Art Market
Research use averaging. The Mei/Moses Fine Art index covers four categories of
paintings: Old Masters and 19th century painting, Impressionist and Modern paintings,
American paintings before 1950, and Postwar and Contemporary paintings. The method
of repeat- sales regression is based on a collection of prices paid for an artwork at
different points in time. For each pair of sales the log-price relative, (Ri), is calculated:
later sale, log (Pt), minus the earlier sale, log (Ps). The log-price relatives are then plotted
based on dummy variables, one for each time period:
Ri = f (D, t)
For the first sale the time dummy, D, has the value -1, for the second sale it has the value
+1. All other dummies have the value 0. 50 The Mei/Moses Fine Art Index has 10,000
repeat-sale pairs of art objects that have sold more than once.
Artprice covers a wider assortment of collecting categories including drawing,
watercolor, painting, tapestry, prints, posters, sculpture-installation, photography and
49
Badie, P. “Property Derivatives: A Brave New World?” May 15, 2007.
50
De Vries, P. & Mariën, G. & de Haan, J. “A House Price Index for the Netherlands: A Review of the
SPAR Method,” 2007, pp. 3.
Olivia Ralevski 31
audiovisual & multimedia. Art Market Research has approximately 500 indexes but its
four most popular are ArtQart, Modern Art, Contemporary Art and American Art. The
averaging method simply gives an average of the artworks sold over a period of time.
This is done by adding up the value of the artworks sold during a given period and
dividing by the number of artworks.
There are obviously a number of problems with averaging including the distortion
caused by a very expensive artwork that can skew the results upward. Art Market
Research does however try to control for this by taking off the top and bottom 10 percent
of its prices. There is also the issue of grouping paintings with different characteristics in
the same period. Repeat-sales regression is a way to avoid the drawbacks of averaging
but it has two major disadvantages. A number of studies have shown that repeat-sales
regression is not the best methodology for heterogeneous assets such as art since it
assumes that all assets are homogenous, sharing the same value appreciation process.51
The repeat-sales data of an artwork is also not very common and hard to trace. A small
data pool cannot therefore be used to build a reliable price index.
A related and fundamental problem that affects all art indexes is that they are
based on auction results and not on private sales. Dealers and collectors do not disclose
the terms of private art sales. Art auction sales make up only approximately fifty percent
of all art transactions. The auction prices that are available however also do not take into
consideration transaction costs (such as tax, insurance, handling, legal and auction fees)
which can vary greatly across works of art. Lastly, like property, art also has a low
turnover rate since it is usually held for long periods of time. Another problem then
51
Peng, L. “Repeat sales regression on heterogeneous properties,” University of Colorado at Boulder,
March 2008, pp. 3.
Olivia Ralevski 32
becomes how often art indexes can be updated to reflect current trends in the market.
The Mei/Moses All Art Index for example is only updated annually. In order to discuss
how art indexes could become tradable, it is important to first look at property indexes,
the most comparable index.
4.1 Using Property Indexes as a Model
Many different property index methodologies exist depending on sector,
(commercial, residential, retail, office and industrial) and country. For the purpose of this
paper, I will focus on commercial and residential indexes in the United Kingdom. I will
also briefly touch upon commercial and residential indexes in the United States since art
indexes are not country specific.
UK commercial property indexes are usually referenced to the UK Investment
Property Databank Indexes (IPD indexes). While a number of other commercial property
indexes are also available such as the FTSE UK Commercial Property Index, IPD is
considered to be one of the most credible indexes available.52 The main IPD indexes are
All Retail, All Office, All Industrial and All Property covering approximately 11,000
properties. From January 2005, all IPD indexes adopted the time-weighted return
methodology. It is calculated in two steps.
52
Giles, S. “Property derivatives come in from the cold,” 2007.
Olivia Ralevski 33
Step 1: Returns and price movements are calculated monthly using the mathematical
formula
CVt - CVt-1 - Cexpt + Crect + Nit

TRt = _________________________________
CVt-1+ Cexpt
where:
TRt = total return in month t;

CVt = capital value at the end of the month t;
Cexpt = total capital expenditure during month t;
Crect = total capital receipts during month t;
Nit = day-dated rent receivable during the month, net of asset management
costs, ground rent and other irrecoverable expenses
Step 2: Results are compounded for quarterly (3 consecutive months) and annual total
returns for the purpose of index construction. Each month is given equal weight
and is why the result is described as ‘time-weighted’. The annual return is
calculated as the percentage change in the index (X1) over the 12-month period.53
Mathematically, this can be expressed by the formula
[(Xt + 12) -1]

Annual total return = _____________________ *100
X1
One of the most popular US commercial indexes is the NCREIF Property Index
(NPI), which stands for the National Council of Real Estate Investment Fiduciaries. This
index is also based on the time-weighted return methodology.
UK residential property indexes are usually linked to the UK Halifax House Price
Index. Many other House Price Indexes (HPI) exist such as the UK Land Registry House
Price Index and the UK FT House Price Index. The Halifax Price Index however has
become the market standard for residential property indexes. There are a number of
Halifax indexes. They vary depending on whether they are new or existing homes and
53
IPD, “IPD Technical Note: Understanding the time-weighted method of calculating investment
performance,” August 2004, pp. 4.
Olivia Ralevski 34
whether they are first-time buyers or home-movers. The most common index is the UK
seasonally adjusted index, which includes all houses and all buyers. The index uses the
hedonic approach to price measurement by valuing the properties according to a set of
particular qualitative characteristics, such as property type and location, and quantitative
characteristics such as the number of bedrooms and the age of the home. The different
property characteristics are then compared over time to build an index.54
Mathematically, this can be expressed by the formula
Pi = b0 + b1X1i + b2X2i + ... +bjXji + ei
where:
Pi, (i=1,2, …, n) is a set of house prices, in a time period (t). For each house
(i), we can represent the price, Pi, as a function of the qualitative and
quantitative variables, X1i, X2i, …, Xji, and their associated coefficients, b1,
b2, …, bj, which indicate the relative importance of the variables along with
a group of randomly distributed factors, ei.
A popular US residential index is the US Standard & Poor’s/Case-Shiller Home
Price Index. This index uses the repeat-sales regression to measure housing markets. As
mentioned earlier, this is not the best methodology for heterogeneous assets such as
property. The hedonic method is a way to avoid the drawbacks of repeat-sales regression
since it allows for the unique characteristics of properties and no double sales are needed.
The hedonic price methodology was created in the 1930’s to allow for comparisons
between automobiles with different characteristics and has been used since for
heterogeneous commodities.55 However, there is no index without flaws. The hedonic
method must rely on the collection of reliable characteristic information from estate
54
HBOS, “Economic View-House Price Index-Index Methodology-The Halifax House Price Index,” 2007,
pp. 2.
55
Edwards, S. “The Economics of Latin American Art: Creativity Patterns and Rates of Return,” 2004,
pp.6.
Olivia Ralevski 35
agents and is based on the assumption that characteristics that are not measured by the
index do not affect value.56 For example, there are a number of characteristics that
influence the value of a property, such as the proximity to local amenities, which cannot
be included because this information was not collected.
The time-weighted return methodology, while being fairly recent is probably the
best method to use for property indexes. Its only disadvantage is that it demands frequent
valuations. This can however be improved with increased liquidity. There is yet another
method mentioned in property literature but this one is strictly theoretical. It is known as
the hybrid hedonic/repeat-sales regression model and was first suggested by Quigley
(2005). The hybrid model combines the advantages of the two methods: for sales, the
hedonic equation is used while re-sales are treated with the repeat-sales equation. While
this method does reduce random volatility it tends to behave more like the repeat-sales
method and therefore suffers from the same limitations.57
Similar to art indexes, there are a number of problems that affect property indexes
due to the heterogeneous nature of property regardless of what methodology is used. The
motivations of the buyer and seller, which would greatly affect the price paid or bought
for a property is not included in the transactions. Nor is the distinction between a change
in the property’s value due to market factors or house-specific factors.58 The frequency
with which the property indexes can be updated to reflect current trends in the market is
another issue.
56
Calnea Analytics, “Land Registry House Price Index-Why Repeat Sales Regression is the Best Method
of Comparison-House Price Reports,” 2008.
57
Thibodeau, T. “Special Issue on House Price Indices,” The Journal of Real Estate, Finance and
Economics, January/March 1997, Vol. 14, No. ½, pp. 63.
58
Ergungor, “Home Price Derivatives”.
Olivia Ralevski 36
Despite these drawbacks, trading on the property indexes and investor confidence
has been strong. Once the benefits of trading property derivatives were realized more
investors came on board which led to increased liquidity, price regulation, and
standardization. A look at the success of property indexes offers much insight into
improving art indexes.
4.2 Improving Art Indexes
Based on a review of the current art index and property index methodologies one
can draw a number of conclusions. The use of repeat-sales regression and averaging is
not the optimal choice for art indexes. The time-weighted method is a possible substitute
due to its minor flaws and proven track record with property indexes. Theoretical
investigations should therefore be conducted on its application to art. The hedonic
method should also be put into practice. Research papers for a number of years, dating
back to Chanel et al. (1996), have argued that this method is particularly good for
heterogeneous assets, like art. Many of art’s unique characteristics such as condition,
provenance and rarity are included in this calculation. In recent years, there has also been
a resurgence of interest on its application to art including Edwards (2004); Higgs and
Worthington (2005); Collins et al. (2007); Kräussl and van Elsand (2008). This has two
important implications. First, the hedonic method is in fact a viable option for art indexes
and more importantly, that the concept of a tradable art index is gaining attention.
The application of the hybrid hedonic/repeat-sales regression model to art has also
been discussed in three papers: Chanel et al. (1996), Biey and Zanola (2005) and Carter
Hill et al. (1997). These papers suggest however that it is difficult to apply to paintings
Olivia Ralevski 37
since characteristics are mainly described by qualitative variables only, leading it to the
same limitations as the repeat-sales regression method.59
A number of steps can be taken in order to bring us one step closer to establishing
a viable art index. The creation of sub-indices that reflect the broad range of genres such
as the Impressionists, Old Masters, Contemporary, and Modern Art should be created.
These indexes must however be supported by sufficient, reliable data which can
sufficiently reflect market risk. This greatly depends on auction houses and particularly
the dealers and collectors, who execute private transactions, to disclose more information.
All auction data however will be available online in five years which will help to improve
credibility.60 Investor confidence in the indexes is also crucial. However, based upon the
success of property indexes, trading is foreseeable in the near future. Lastly, finding an
appropriate methodology would also be beneficial. It is clear that the most suitable art
index methodology has not yet been determined. It is therefore imperative to participate
in objective debates about the different indexes. I hope that this paper has made a
positive contribution in this regard.
59
Chanel, O. & Gerard-Varet, L, Ginsburgh, V. “The Relevance of Hedonic Price Indices: The Case of
Paintings,” Journal of Cultural Economics, 1996, Vol. 20, Issue 1, pp. 7.
60
This was discussed in an interview with Jessica Knopp-Gwynne, United States Business Head of Fine
Art Wealth Management.
Olivia Ralevski 38
Hedging the Art Market: Creating Art Derivatives Conclusion
Chapter 5 – Conclusion
What does the future hold then for art derivatives? When asked if there is a future
for structured products with art as the underlying, Chris Carlson of the Art Trading Fund
said “absolutely…I think they are just around the corner”.61 There is clearly enormous
market potential and it should be brought to the attention of the commercial market for
future development. A commercial proposition for an art derivatives market is therefore
presented in the appendix.
The use of equity derivatives by an art investment fund, the Art Trading Fund, to
hedge against the art market in 2007 and the idea of applying credit derivatives to reduce
risk in the art market presented by Campbell and Wiehenkamp in 2008 suggest that
things are beginning to gain momentum for this class of assets. Moreover, experience in
other asset classes such as the property derivatives market suggests that the market could
grow rapidly once it achieves momentum. The property derivatives market has had a
very successful year so far in 2008, totaling 17 billion pounds in trades on the IPD
Indexes.62 An art derivatives market is also perhaps not unthinkable considering that new
derivatives are being developed on earthquakes and the credit ratings of investors.63
The need for an art derivatives market to manage risk and uncertainty as well as
bring liquidity and efficiency to the art market is well overdue. The art market is
characterized by high illiquidity, inefficient market information, high transaction costs,
long transaction time and the absence of a hedging mechanism. Art is also a
heterogeneous commodity which makes it difficult to value and trade. Art derivatives
will therefore remove difficulties in calculating risk and return profiles and provide the
61
Wealth Briefing, “The WB Art Interview: The Art Trading Fund, Chris Carlson,” Nov 7, 2007.
62
Fenlon, “UK property derivatives-a focus on residential”.
63
BBC News, “Derivatives-a simple guide”.
Olivia Ralevski 39
liquidity and regulation for future investment. Case, Shiller and Weiss (1993) suggested
that derivatives have a positive effect on the economy by evening out cycles.
The art derivatives market is a likely extension to the current derivatives market
given the size and scale of the art market.64 The wealth of high net worth individuals is
currently estimated at over $30 trillion and increasing at 7 percent per year. It is also
believed that $300 billion of this wealth is used for art investment.65 These individuals
are also resisting fears of the sub-prime crisis and credit crunch, driving sales in the art
market beyond expectations.
There are therefore numerous benefits for potential buyers of these derivatives
which include pension funds, hedge funds, private art collectors, galleries, or anyone
interested in the art market. Potential benefits include limited start-up cost with a low
financial commitment consisting of broker fees and a spread to the investment bank. The
removal of high transaction costs associated with art purchases (such as purchase tax,
insurance, handling, legal and agent fees), which often go above 5% of the purchase
price. Art derivatives also permit tailored transactions such as the timing of the
investment, the terms and the amount, and quick executions. Overall, they offer a more
flexible way to hedge art investment risks without direct art investment.
In conclusion, there are a number of suggestions I would like to propose for the
future development of a viable art derivatives market. My suggestions will focus upon its
two main obstacles: the improvement of market liquidity and the development of reliable
art indexes.
64
Badie, “Property Derivatives: A Brave New World?”.
65
Mamarbachi, & Day & Favato, pp. 6.
Olivia Ralevski 40
New financial products depend highly on institutional attitudes.66 It is therefore
imperative for market participants like investment banks to demonstrate strong leadership
and begin to offer art structured products to their clients. Banks can greatly enhance
liquidity by marketing this new product and also educating the public while remaining at
the forefront of investment product development. A survey to identify investors’ interest
level in art derivatives and their concerns would be the next logical step to gaining
institutional acceptance. An excellent model for this survey is a recent survey conducted
by the MIT Centre for Real Estate which can be found in the appendix. The survey
conducted from June 14th to July 14th 2006, looked at the interest among US investors for
the use of property derivatives. Various types from the investor community were
included in the survey including investment managers, fund mangers, commercial
lenders, and brokers. None of the participants held negative views about the market (see
question 19 of the survey) and two thirds of the respondents chose hedging property
exposure as their main intention (see question 8 of the survey). More than 80% of the
respondents cited liquidity as their biggest concern (see question 6 of the survey).
Increased institutional participation will also help the development of reliable art
indexes by promoting information disclosure among dealers and collectors. This in turn
will enforce standardized methods of data collection and assist in finding the most
suitable art index methodology. A regulatory framework might then be created to
supervise transactions. 67
The recent financial turmoil has demonstrated the need for risk management, and
the art market is no exception. Art derivatives can revolutionize the art market by
66
McAllister, P. & Mansfield, J.R. “Investment property portfolio management and financial derivatives:
Paper 2,” Property Management, 1998, Vol. 16, No. 4, pp. 212.
67
Property Derivatives Study Group, “Property Derivatives Study Report,” 2007, pp. 82.
Olivia Ralevski 41
offering a simpler and easier way to manage the risk and return of art. They will also be
a “testament to the financial world’s ability to commoditize, securitize, and trade just
about anything”. This is demonstrated by the cartoon below (Figure 9), in which two
sheiks are discussing their investments and the caption reads “Through it all we’re still
heavily invested in oil – primarily Picasso and Rembrandt”. I hope that my suggestions
will promote investor awareness and begin a debate among the worlds of art and finance
on the advantages of creating art derivatives.
Figure 9: Eric Teitelbaum Cartoon in The New Yorker, 1990
Olivia Ralevski 42
Hedging the Art Market: Creating Art Derivatives Appendix
Appendix
Olivia Ralevski 43
Hedging the Art Market: Creating Art Derivatives Appendix 1
Appendix 1: Commercial Proposition for an Art Derivatives Market
How far are we from the day when an investor can buy an Impressionist derivative
instead of a Manet painting?
The Emergence of Art Derivatives
- In 2007 equity derivatives were used by an art investment fund to hedge against
the art market, the first use of derivatives in conjunction with art
- A true hedge for art requires a derivative with art as the underlying
- Art derivatives will manage risk and uncertainty in the art investment process,
bringing liquidity and efficiency to the art market
- Property, the latest asset class to develop a derivatives market, totaled $35 billion
in trades on the IPD indexes in 2008
The Need for Art Derivatives
- Art is heterogeneous making it difficult to value and trade

- The art market is characterized by high illiquidity, inefficient market information, high
transaction costs, long transaction time and absence of a hedging mechanism
- Art derivatives will remove difficulties in calculating risk and return profiles and
provide the liquidity and regulation for future investment
- Sales in the art market continue to surpass expectations, suggesting art is one class
of investments immune from the current economic downturn
- Art is negatively correlated to traditional asset forms. It is a defensive asset
- Huge market potential with HNWI wealth currently estimated at over $30 trillion and
increasing rapidly at 7 % per year. $300 billion of this wealth is used for art investment
How it Works
Motives to Invest
- Potential buyers: pension funds, hedge funds, private art collectors, galleries, anyone
interested in the art market
- Limited start-up cost with a low financial commitment consisting of broker fees and
spread to the investment bank
- Removes high transaction costs associated with art purchases (purchase tax, insurance,
handling, legal and agent fees, which often go above 5% of the purchase price)
- Art derivatives permit tailored transactions and quick executions
- More flexible way to hedge art investment risks without buying art
Olivia Ralevski completed her MBA dissertation entitled “Hedging the Art Market: Creating Art Derivatives” at the
University of Edinburgh Management School in 2008.
Olivia Ralevski 44
Appendix 2: US Investor Survey on Real Estate Derivatives Result-
Conducted by the MIT Centre for Real Estate
Olivia Ralevski 45
Olivia Ralevski 46
Olivia Ralevski 47
Olivia Ralevski 48
Olivia Ralevski 49
Olivia Ralevski 50
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UNIVERSITY OF EDINBURGH

Hedging the Art Market: Creating Art Derivatives

Dissertation Presented for

the Degree of Master of Business Administration

©Olivia Ralevski, 2008

Table of Contents iii

About the Author v

Chapter 2 - Art as an Investment Vehicle 4

2.1 The First Art Investment Fund 6

Chapter 3 - The Creation of Art Derivatives 16

3.1 The Success of Property Derivatives 16

Chapter 4 - Art Indexes 29

4.1 Using Property Indexes as a Model 33

Appendix 1: Commercial Proposition for an Art Derivatives Market 44

Olivia Ralevski iii

Figure 1: Francis Bacon (1909-1992) Triptych (1976) Oil on Canvas 4

Figure 3: Hermann-Paul Cartoon of La Peau de l’Ours in the French

Figure 4: Monthly Annualized Turnover Rates of Single Family Properties

Figure 5: Credit Derivatives Market between 1996 and today 22

Figure 6: Proposed Model for a 2-Year Total Return Art Swap 24

Figure 7: Édouard Manet (1832-1883) Le déjeuner sur l’herbe (1862-63) 26

Figure 8: Sample Index of Modern European Painting from 1975 to 1999

Figure 9: Eric Teitelbaum Cartoon in The New Yorker, 1990 42

About the Author

offer a hedge against the art market by using equity derivatives.

1.2 Scope of Work

regulation needed as well as stimulate future investment. In chapter three, I propose a

derivatives markets. The property derivatives market is a very useful comparison

The successful creation of art derivatives depends on the development of reliable

use weak methodologies to provide an accurate description of art’s performance.

sub-indices, choosing a suitable index methodology, and promoting information

a comparison because it is the most comparable index.

purchases, limited start-up cost with a low financial commitment, customized

Chapter 2 - Art as an Investment Vehicle

Figure 1: Francis Bacon (1909-1992) Triptych (1976)

Art is in high demand because it is a unique commodity that is in limited supply.

composed of heterogeneous products that is highly illiquid, inefficient and unpredictable.

credit crunch and sub-prime crisis.

through its ability to provide diversification benefits to investment portfolios. For

2.1 The First Art Investment Fund

The art investment fund originated in the early twentieth-century in France.

have a beautiful collection of futurist works.6

Figure 3: Hermann-Paul Cartoon of La Peau de l’Ours

2.2 Modern Day Art Investment Funds

approximately 50 funds attempting to launch.8 Charles Saatchi, a famous UK art

wealth is used for art investment.10

institutions and individuals. Money to purchase art is generated through targeting

Art Fund and a Middle Eastern Fine Art Fund.12

Furthermore, in an interview with Jessica Knopp-Gwynne, United States Business

its goal of $50 million.

down from fifty in 2001.16

2.3 The Low Success Rate of Art Investment Funds

reliable source of information available on the investment performance of art.

and transparency. There is no one accepted valuation methodology that dictates

of the purchase price).

and regulation needed as well as stimulate future investment.

2.4 Hedging Using Derivatives

Hedging techniques usually involve the use of financial instruments known as

derivatives. According to Alan Greenspan, former Chairman of the Board of Governors

as the underlying without having to purchase it.

description of an asset’s performance.

2.5 Art Hedge Funds