Basics -Hedging

I was recently reminded that for all of the discussions here on pricing, that I hadn’t shown a basic “how to hedge” example using the CME Home Price futures.  Let me rectify that with the following illustration.

The graph to the right illustrates the P&L impact of a change in the value of a hypothetical $1mm house (for ease of math) over a holding period through the expiration of the Nov 2014 contract.  The steepest line indicates what everyone learned during the 2000 decade -that you can make (or lose) a tremendous amount of money as home prices move up or down. 

A key assumption in all three lines is that the price of this house moves in tandem with the Case-Shiller (CS) price index for the region.  For the unhedged version, that means that if the house was bought when the current index is 172.76, that the value of the house will change (on a percentage basis) as the index changes.  So, should the index be 200 in Nov 2014 (for a 15.8% total increase or a 3.5% HPA over the 4.25 years) then the $1mm home price would rise in value by the same percent change. 

Is this realistic?  Will all home prices move in tandem with the index?  Of course not, and it’s important to appreciate and incorporate that into one’s analysis.  The CS index doesn’t include houses with significant alterations or upgrades.   There may be sub-regions that due to new business, new highways, new schools, may see price changes that are different from the overall index.  Finally, no one can hedge against someone paying 5% too much for a house, or selling one at a distressed level.

That said, I go back to the website cover page and ask, has the price of your home moved generallyalong the index price path for your region.  In most cases, the answer is that index price changes, that is changes to overall home prices in the region, account for the bulk of individual home price moves.  Could your home’s “value” go down by 5% while the index goes up by 5% -YES, and if you’re going to hedge you have to know that (or worse) is a possible result.  However, the Case Shiller index attempts to measure average home prices, and if average home prices rise or fall 10%, that would mean most homes moved in the same direction.

Going back to the illustration above, the two flatter lines indicate the net P&L of hedging a portion of the house’s value with a sale of CME contracts for the NYM region on the Nov 2014 contract.  With the same qualifiers as above, it illustrates the notion that while you can’t sell a portion of your house, you can hedge as much of their house’s value as you care.    As with all hedging strategies, the more of the underlying value that is hedged, the flatter the net P&L.

So, as the table to the right shows,  if the index goes to 200, and the house rises in value by the same percent to $1,157,675 the gain of $157,675 on the house will be offset by the loss on the contracts.  If one had sold 5 contracts that would be a $33,750 loss for a net gain of $123,925.  (Recall that each contract has a value of $250 times the index price divided by 100.  As such 5 NYM contracts at 17300 have a notional value of $216,250.  Twenty contracts would have a notional value of $865,000). 

The key conclusion is that hedging has the potential to dampen losses if one is willing to forgo some of the upside.

 A few important points:

1) I used this example (NYM) because the Nov 2014 contract was bid (173) at almost the same level as the  most recently released index (172.76)  For other regions, and during other times, the forward price might be a premium or discount to today’s spot CS index.

2) The benefit of using the Nov ’14 contract is that it hedges the value of the house for four years.  Today it is the longest dated contract.  As time passed new contracts for Nov 2015 and beyond will be rolled out and a homeowner/hedger can determine whether they want to extend their hedging time-frame.

3) If the owner holds the house and the hedges through Nov 2014, there is nothing that they need to do to unwind the hedges.  The closing value for the Nov 2014 contract will be the Case-Shiller index value announced that month.  Note, though that if the hedge matures without  a new one being put in place, that the homeowner will not have any hedge protection after that date.

4) If the owner sells the house before that period, they can independently decide what to do about the hedges.  If they are moving within the region, they may consider keeping the hedges on.  If they’re downsizing, moving to a rental, or leaving the region, they may want to “lift” (buy back) the short positions.   Prices for all contracts (including this Nov 2014 example) may vary during the life of the contract and there’s no guarantee where prices might be, or even that (in this example) the Nov 2014 price will not be at a premium or discount to the then current Case-Shiller index. 

5) Just as hedging can’t protect one from overpaying 5% for a house, the same applies on the initial futures execution (and unwind if lifted before maturity).  The Nov 2014 contracts tend to have wide bid/asked spreads, with limited depth (# of contracts that can be traded at at price) and I would strongly encourage anyone using those contracts to work with limit (as opposed to market) orders, and to consider starting with offers inside the current bid/asked spreads.

With all of these caveats I do believe that this may be an interesting product for those considering hedging.   Most people buy houses to stay in them for a while, yet the results of the last few years show the downside of unhedged positions.   Using these futures as a hedge MAY offset the risk of large region-specific price declines over longer time frames.

As with all of my blogs and comments, but particularly with this one, this should not be considered investment advice or an offer to buy or sell contracts.  Traders should consider their own unique situations and discuss the ramifications to any trade with their own tax, investment and accounting experts.  While a number of risks were outlined, it is not an all-inclusive list and events and price moves could occur that might cause a trader to lose a significant amount of money.  Only those who fully understand the issues associated with hedging should consider hedging strategies.  Anyone trading CME Home Price futures should understand the nuances of the Case-Shiller index calculation.  Margin calls might require cash outlays before the end of the contract that may require the hedger to post more collateral.  The results shown here are hypothetical, may not be applicable to your situation and are used for illustration only.  These are my views and they should not be inferred to represent the views of the CME, S&P, FISERV or anyone associated with the Case-Shiller index.