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Housing futures
Read James Surowiecki. Excerpt:
At a new online site called HedgeStreet, investors can bet on changes in home prices in certain cities. And later this month the Chicago Mercantile Exchange is going to start trading futures contracts pegged to housing-price indexes in ten major metropolitan areas. The Chicago plan, which is the brainchild of two economists, Karl Case, of Wellesley, and Robert Shiller, of Yale, is straightforward: if you just spent, say, $1.5 million on a two-bedroom apartment in Manhattan, and you want to hedge against the risk that it might be worth $1.2 million three years from now, you can sell contracts that will reap you a profit if local prices fall, allowing you to lock in the current value of your home. Alternatively, if you think the housing boom in Los Angeles still has a ways to run—or if you’re interested in buying a year from now but are afraid that you’ll be priced out of the market—you can place a bet that will pay off if prices keep going up.
Posted by Tyler Cowen on May 1, 2006 at 07:25 PM in Economics | Permalink
Comments
I've got to think that a "costless collar" option trade, in which the homeowner writes a covered call giving up all upside beyond $X in exchange for protecting his downside beyond $Y, is (a) both the most popular/liquid use of these indices (and derivatives thereupon) and (b) heavily skewed in favor of speculators at this point. Wouldn't all the panicky homeowners rush to lock in home equity?
On the other hand, this allows a risk-averse homeowner to lock in a gain without having to incur the frictional transactions costs of moving house. You can always buy back your short contract at a loss (offset by the paper gain on your home) and sell a higher one, taking tax-deductible capital losses over time and never needing to move.
Posted by: ModalHubby at May 1, 2006 8:59:24 PM
Vol is likely to be very cheap if people engage in the rational zero cost collar trade, that's for sure. But lets get real here - unless such a product is stapled to a loan and provide potential cash in the event of personal income stress and housing market declines (not inconceivable) it really isn't going to help someone service their mortgage when times get tough, especially if homeowners can't readily onsell their option (ie, extract premium) or don't have american style exercise. If you've already lost your house due to not being able to service the mortgage a european option is not going to be that helpful.
Another thought exercise: so if rental flows are the dividends of the home asset, then do we take into account these in determining the forward rate? Is F=S0(e^([r+y]t))? where r is financing cost and y is the rental yield? If the writer of the option forgoes the rental yield (strict price return) then could you get a negative forward rate?
Posted by: Alex Turnbull at May 1, 2006 10:20:26 PM
I think this is a market for a "strip" home security, much like a stripped T-bill. The coupons belong to someone else, who is not necessarily either the buyer or the seller of the index. In the case of a hedging resident homeowner, the home owner is both the option writer and the owner of the coupons, but conceivably a professional landlord (or developer) could "sell the coupons" by renting the dwelling for cash, and "sell the strip" in the forward market to lock in a future capital gain, which would then be accepted as collateral by a lender today.
If we consider depreciation on the house as a natural byproduct of having someone live there, which reduces the future value, a negative forward rate seems quite reasonable.
Posted by: ModalHubby at May 2, 2006 12:08:45 AM
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Posted by: Anonymous at May 2, 2006 12:50:36 AM
Alex, you want to subtract the y (and convenience yield?) Add depreciation & maintenance.
Shiller said that he thought the futures would settle into backwardation, although he was coming from a Keynesian hedging angle as opposed to cost-of-carry.
Does anyone have a copy of Holbrook Working's paper on Wine Futures?
Posted by: Jason Ruspini at May 2, 2006 11:29:18 AM
There are apparently several companies that are looking at offering equity insurance using the CME indexes as a hedging instrument. The main problems that exist as far as I know is that individual properties won't neccesarily directly reflect the movement of the index.
As best as I can tell the most likely users of the index as a hedging instrument will be housing developers.
I don't know much about options, but I am in the Real Estate industry, and I see tremendous potential in the CME 's index. I bet with the right minds, someone can manipulate markets and make a killing on the CME index. I personally identified a margin bet opportunity in Real Estate, and think it can be used to straddle the CME housing index. However, I don't know enough about options to work the numbers. If there is anyone out there who can direct me to resources on understanding the economics of options, i would greatly appreciate it.
I see the CME's housing index as a potential gold-mine and would love to get involved, any ideas would be great.
The great thing about this is that i am yet to meet a seasoned R.E. investor aware of the opportunities this new index presents, so that affords all the more opportunity.
Apparently the U.K. has been doing this for several years, and they even offer the opportunity to buy a virtual house in different neighborhoods. Where you gamble on the movement of the neighborhood.
Posted by: David M at May 2, 2006 12:50:44 PM
The basis risk is huge for these indices - ie, your house price moves by x. index moves by something much larger.
As for an accurate forward rate, I think you have to separate the land and build entity, after all, the land is scarce and depletable (in most cities - ex transport tech) whereas the built good is subject to depreciation and maintenance. So, a forward might look something like the following:
F=(construction cost/total cost)*Total cost*(e^(r-u)t)+(land cost/total cost)*(e^(r+y)t)
As for using these as a hedging instrument, I think you'd have to hedge a portfolio instead of just hedging single assets, homeowners and the media would have a field day oer the first person to get blown up by basis risk.
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Posted by: linda at Oct 10, 2006 8:23:56 AM
was wondering how the housing index futures are trading today and what are(s) of the country are using them most successfully. Thank you.
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