Do you think that the price of your home is about to fall, or that the value of a rental property you bought years ago might decline? Are you confident that house prices will continue rising in Denver, or that house values in Boston are going to flatten? Starting in April or May, you will be able to bet on it or hedge against such outcomes.

 

The Chicago Mercantile Exchange (CME), the same institution that deals in the value of commodities (pork bellies, orange juice, etc.) foreign exchange (Euros, Japanese yen, Canadian dollars, etc.), and the direction of interest rates and stock prices, has recently committed to start trading index-based futures and options on futures in a item near and dear to Americans —home prices. 

 

Futures and options originally were based on physical commodities. Later foreign exchange and other financial instruments were added. More recently trading has been extended to index-based futures involving no physical items or actual securities. Index-based instruments derive their value solely due to changes in an index over time.  When the future or option expires, settlement is always in dollars, and whether an index-based transaction is considered speculative or a hedge, depends only on whether the investor is increasing their exposure, or covering an existing position.                 

 

Starting this spring, index-based housing price futures and options on futures based on indexes depicting matched sales prices for single family residential dwellings in 10 different U.S. cities will begin trading. Investors will be able to trade contracts based on an index of median home prices in the metropolitan areas of Boston, Chicago, Denver, Las Vegas, Los Angeles, Miami, New York, San Diego, San Francisco, or Washington, D.C. or in a composite index of all 10 cities. Although individual home owners may participate, the new futures and options are designed more for housing industry participants such as home builders, mortgage lenders and investors, developers, residential real estate investors, individual landowners, hedge funds and others with generally large positions in real estate. These investment products will also allow investors with no real estate exposure in their portfolios to quickly, easily and cheaply access this large and recently fast growing market by either purchasing futures or more likely by buying options. This will allow for increased portfolio diversification for, at most, the cost of the options.

 

After the recent run up in property values across much of country, owner-occupied  residential real estate in the U.S. is now worth well over $18 trillion, more than the value of all U.S equities and just slightly less than the value of all U.S. fixed income securities [1]. Although many complex financial instruments like futures, options, and others exist in the equities and fixed income markets, virtually none exist in the market for single family homes despite its importance, size and complexity.

 

In a futures contract, one party agrees to purchase an asset from another party at a specific date in the future at a price set currently. If the price of the asset declines in the interim, the seller can at the future date acquire the asset more cheaply and turn it over at an instant profit. If the price has increased, however, the seller would realize an instant loss.

  

As an alternative to buying or selling futures, investors can buy or sell options. There are two types of futures options: “calls” and “puts”. A “call” is an option to purchase an asset at a fixed price, usually referred to as the “strike” price. A “put” is an option to sell an asset at a strike price.  In order to acquire the right to exercise an option at some point in the future, it’s necessary to pay for it.  Unlike a futures contract, the advantage of an option is that the buyer of an option never risks more than the cost of the option. If the price of the underlying index changes in an unfavorable direction, you simply never exercise the option, and it expires worthless. Again, there is no actual transfer of asset ownership, and gains are realized simply by selling the option.

 

In the markets for many assets, it is quite common for investors not only to speculate on rising prices, but to hedge against falling prices through the use of complex financial derivatives. The CME is extending this to the market for owner-occupied housing by making available futures and options based on house price indices. The indices will use the Case-Shiller Indexes (CSIs), which are based upon repeat sales of existing homes much like the Office of Federal Housing Enterprise Oversight (OFHEO) indices, although with some improvements. The CSIs are based on a wider sample of home sales —as they are not confined to Fannie Mae and Freddie Mac conforming loan limits and therefore are not biased towards less expensive housing [2] —and do not use appraisal data—which may be biased upwards.

 

The new contracts will have standard expiration dates of March, June, September and December and will enable investors to hedge against declining house prices for the first time. They will also allow a broader class of investors to invest in a geographically diversified portfolio of real estate assets without incurring punishing transaction costs. Up to now this has been all but impossible except for the largest investors, despite the fact that real estate is such a large percentage of total wealth in the U.S. Although it’s unclear at this stage who, if anyone, is likely to be a heavy investor in the new housing futures and options, there are several classes of investors who may be potentially interested.

Although there has never been a year-over-year decline in national house prices since it has been possible to measure them, declines in local housing markets have occurred. In Los Angeles and Hartford, home prices fell 19 percent and 17 percent respectively between 1993 and 1998. In Honolulu, home prices declined by 16 percent between 1996 and 2001. In Anchorage, Austin, Fort Worth, Houston, Oklahoma City, and San Antonio, house prices fell between 17 and 40 percent between 1985 and 1993. [3]

 

Homeowners can often avoid some of the problems associated with a poor housing market by delaying the sale of their homes —either staying in their homes for a few more years or renting them— but home builders are generally not so flexible. If market conditions shift so that a recently built spec home can now only be sold at a loss, the costs of carrying the inventory will accumulate while the home remains unsold. Rather than leaving local market conditions to chance, builders could choose to be proactive and either sell futures or buy put options that protect them against losses, or sales delays due to cancellations, much like farmers sell futures and options on corn, soybeans, wheat and cattle, timber companies sell futures and options on lumber, sugar growers sell futures and options on sugar, and coffee growers sell futures and options on coffee beans.

                

Home builders (and sellers of existing houses) might consider offering buyers in high price housing markets a put option as a form of temporary price insurance to ease their fears about buying at the peak of the market. Armed with this option, any subsequent house price decline will be largely matched by an increase in the value of the put option.

 

The situation is similar for developers who own residentially zoned land, as the prices for this land will tend to move in the same direction as house prices. Rather than simply absorb a decline in the value of the raw land or developed lots they hold, developers could sell index-based futures or buy put options on the index-based futures to help protect themselves against price declines.

 

The CME’s new financial products will allow investors with little or no current real estate exposure to purchase a diversified portfolio of real estate assets by buying futures or call options on the appropriate house price index. In this way these investors could add a diversified residential real estate component to their portfolio without substantial cost, thereby adjusting the overall risk-return characteristics of their portfolio because bond and stock returns are both poorly correlated with residential housing returns.

 

Similarly, investors (like builders described earlier) who expect residential real estate prices to decline will be able to sell futures or buy put options. Likewise, large investors with mortgage holdings who have substantial exposure in a market where they fear declining prices and increased default rates may be interested in futures and options in that particular market.

 

A current home owner who wants to buy a different home in a different area is another potential investor in the new financial instruments. A household thinking of buying a new home in San Diego or Las Vegas may be concerned about the price of its current home in Miami or Chicago falling before it can be sold and the proceeds used to pay for the new house. Similarly, a renter family that suddenly finds it has twins on the way may want to buy a house in the next six to twelve months but may be fearful of being priced out of the market if recent price increases in that market continue. Futures and options allow prospective buyers to hedge against these possibilities.

    

It has always been possible for those who believe prices are going up to speculate in residential real estate. The new futures and options contracts open up the possibility of hedging against declines as well. Hedging is undertaken by those who wish to reduce the risks of prices falling (or rising) between the time they make a financial commitment and the time it is completed.

 

For example, from start to completion it takes four to six months to build a house. Thus, a builder could hedge against price reductions during the four to six month period by either selling housing futures six months forward or buying a put option with a six month life when home construction starts [4].  After four months, when the house is sold, the builder would then buy a futures contract two months forward or a call option with a two month life to cancel the earlier future or option transaction. Because the price of the newly built house and the price of the futures or options tend to move together, any decline in the house price over the construction period will largely be offset by the gain from the futures or options transaction.

 

Example 1 

A builder starting a $4,987,680 subdivision in Los Angeles in March is fearful prices may fall before the houses are sold in September. In an attempt to completely hedge all risk, the builder sells $4,987,680 worth of six month (September) futures contracts. Note, the duration of the contracts (six months) are equal to the duration of the risk, and the value of the contracts are equal to the value of the project. The CME has arbitrarily valued each future contract at $250 times the particular CSI value. Thus, if the CSI future value for September 2005 L.A. contracts in March 2005 is 207.82, then each September L.A. CSI future contract is priced at $51,955. While it is not possible to buy less than one contract, the CME is expected to only require participants in this market to post a performance bond, or escrow money, of two to four percent of the value of each contract bought or sold, or about $1,000 to $2,000.  When the contract expires or the position is closed, the value of the bond less any loss on the position is returned. All indices have a base value of 100.00 in Q1 2000.

      

If L.A. house prices were to decline, the builder is $427,680 better off for having sold September L.A. futures. This example was constructed to illustrate a perfect hedge, where gains on the futures contract fully offset the loss on the house sales, and the builder sustains no loss. The example assumed there were no transactions costs. In practice there would be nominal transaction charges[5], and this would therefore be a somewhat less than perfect hedge.

 

In general, hedging can work this way, because the risk of losses on price changes is shifted to speculators who are willing to assume the risk in a quest for profits. In the process, the speculators essentially provide insurance services to home builders, home owners, mortgage holders and other parties that are active in real estate and wish to reduce risk.  
 
If there were instead an unanticipated increase in house prices the builder would have been better without the futures, as the gains on the sales of the houses are offset by the loss on the September L.A. futures —which becomes profit for the speculators. Example 1 also shows another “perfect” scenario, in which the losses on the futures contract perfectly offset the profits that would otherwise have been made from rising house prices. This illustrates an important point about hedging. It can help protect against losses, but will not increase profits, and will actually reduce profits if prices move in an unanticipated direction.

 

Example 1
Transaction Date	March 2005	September 2005	September 2005
Eventual Outcome		Price Decline	Price Rise
Case-Shiller Index City	Los Angeles	Los Angeles	Los Angeles
Expiration Date of Futures Contract	Sep-05	Sep-05	Sep-05
Current CSI Value for L.A. Sep-05	207.82	190.00	225.00
Price per Contract	$51,955	$47,500	$56,250
Number of Contracts	96	96	96
Value of Contracts	$4,987,680	$4,560,000	$5,400,000
Capital Gain or loss on Futures	NA	$427,680	-$412,320
Capital Gain or Loss on House Sales	NA	-$427,680	$412,320
Net Capital Gain or Loss	NA	$0	$0

 

 

If a similar builder is less certain that prices will fall, or thinks that they will probably fall but there is also a chance that they may rise, or that he or she can now sustain some financial loss, the builder may elect to hedge only half of the risk involved, instead of all of it as in Example 1. This builder could sell half as many September L.A. futures contracts in March and the situation would be as follows in Example 2:

    

In this case, the builder loses some money if prices fall, but makes some money if prices rise.   Thus, how and how much you choose to use these instruments very much depends on how much risk you are prepared to incur, what direction you think prices are moving in, the volatility of the hedged asset, and basis risk.

 

Example 2
Transaction Date	March 2005	September 2005	September 2005
Eventual Outcome		Price Decline	Price Rise
Case-Shiller Index City	Los Angeles	Los Angeles	Los Angeles
Expiration Date of Futures Contract	Sep-05	Sep-05	Sep-05
Current CSI Value for L.A. Sep-05	207.82	190.00	225.00
Price per Contract	$51,955	$47,500	$56,250
Number of Contracts	48	48	48
Value of Contracts	$2,493,840	$2,280,000	$2,700,000
Capital Gain or loss on Futures	NA	$213,840	-$206,160
Capital Gain or Loss on House Sales	NA	-$427,680	$412,320
Net Capital Gain or Loss	NA	-$213,840	$206,160

       

 

Other Complications
In the example above the index futures worked as a perfect hedge against house price changes.  In addition to transaction costs, there are other reasons house price futures and options may in practice be imperfect hedges.
 
• The houses being built may not be like the median house.  Because the index tracks the price performance of thousands of houses, there is no reason to believe that the housing being built will behave exactly like the index. For example, the houses in question could be much more expensive than most and as a result may suffer a larger price decline because of the thinner market. 

 

• The cost of housing inputs changes over time. That is, the cost of framing lumber, gypsum, gasoline, bricks and other housing inputs change, and these changes may not be highly correlated with the local house price index. For example, gypsum prices may jump dramatically yet will probably not strongly affect the house price index in a particular city.

       

• The houses in the above example are all in one location and that location is unlikely to behave like the index, as the index looks at the median of the entire area. For example, the New York MSA house price index is composed of 29 counties, in four states. Thus price fluctuations in one subdivision are unlikely to be perfectly correlated with the movement of the overall NY index.    

 

• The value of the project will not exactly match the dollar amount of a round number of contracts and thus not all risk can be hedged. In the above example, if the builder wanted to hedge $5,000,000 worth of construction activity, a little of it would not be able to be hedged as each contract costs $51,955.

 

• With any large development new home sales are spread over a long period of time.  As a result, a single hedge cannot cover the entire build-out period. Unless new futures contracts are continually purchased as construction on new houses is started, all price declines will not be hedged and those price changes will be borne by the builder. 

 

Collectively these factors are referred to as “basis risk” or the risk that the hedging instrument is not perfectly correlated with the item it is designed to protect. To the extent that basis risk is low, the hedge will more easily protect the builder, and will be simple to use as a hedging instrument. Conversely, as basis risk increases more complex hedging strategies will be necessary to achieve the same level of protection.

 

The new house price futures and options contracts that the CME is planning to offer will provide builders and developers with tools for hedging against declining house prices. The financial contracts are complicated and can be difficult to understand for novices, however. If used unwisely they (especially the futures) can wipe out profits or result in very large losses.

 

The CME intends to offer futures and options for ten large, metropolitan market areas.  A composite index based on all ten areas will be available that could be used to hedge against house prices declining in general across the country. Based on past experience, however, the prospect of general and widespread price reductions seems remote, so targeted uses of the new investment products in particular local markets seems more likely.

 

Assuming that builders most often start the building process in places where they believe housing demand is strong and there is upward pressure on prices, we would not expect hedging against falling prices to become standard operating practice. Limited hedging in cases where local market conditions shift during the build-out is a possibility, particularly with options where the downside risk is limited.

 

Possibly the most intriguing use builders could make of housing futures and options is as an inducement to prospective buyers, especially those who appear to be putting off the purchase decision because they fear local house prices are at a temporary peak.