Monday, September 04, 2006

The Chicago Merc Housing Futures Market

Chip Case and Robert Shiller have created a housing futures market for 10 US cities, along with a composite of those cities, that trades on the Chicago Mercantile exchange. If it works, it will allow homeowners to diversify some of their risk, and presumably make the market more liquid.

Owners who have lots of of home equity are long in the housing market. This may be fine, but it also may be that their length in housing means that they are not as diversified into other assets as they may wish. The CME index can help.

Here is how it works. Suppose you own a house in Washington, D.C. The most recent index value for Washington is from June, and is 250.39. The next futures contract is for November, and currently has a price of 247.8. If you take a short position for November, you have the right to sell the Washington index at 247.8 per unit. If the value of your house us perfectly correlated with the index, you can completey immunize yourself from swings in the market, outside of the difference between the June index and November price. If the price falls below 247.8, the profit on your short position will offset the loss in house value; if the price rises above the 247.8, your house offsets the loss on your short position. All of this assumes that there are no tax implications, but even with taxes, the index enables homeowners to at least partially hedge their risk.

All of this should actually make houses more valuable, because it should increase liquidity in the housing market. There remain some issues--chief among them is the lack of a true spot market in housing, because of the lag in the time between when a house receives an offer and when it actually settles. I'll discuss this further in another post. I will also discuss what the futures markets are saying about the future of house prices, and the implications for the own-rent decision.

1 comment:

Andy said...

There is also a 'retail' hedging instrument at They are binary options on specific cities. Just an interesting comparasion.