With the upcoming expiration of the Feb 2024 (G24) CME Case Shiller home price index contracts, it's a good time to revisit the concepts of cash settlement and convergence. (Note #1- that the G24 contracts will settle on the index values released tomorrow -Tuesday Feb 27 -at 9 AM Eastern. Note #2 -trading in the G24 contracts closes at 3 PM today, an hour before the other expirations).
The graph below shows the price history of the CME 10-city index contract (in red) superimposed on a graph of the Case Shiller 10-city index. Note that there were times (e.g. spring/summer 2021) when the contract was quoted higher than the then-current index, and other times (e.g. summer 2022) when the contract closes were below the then-current index. This point is emphasized in the graph with the labels that the contract prices are forward looking (to include some element of "what will the index be at expiration" -among other factors) while the index looks backwards two months to a rolling three-month period.
The power of the contract prices as a partial forecast of the future is illustrated by the peak in contract prices in May 2022, well before index values began to slide. (Net, users should pay more attention to forward-looking contract prices, rather than having a 100% focus on "where have we been').
However, regardless of the paths the contract prices and index values take, they converge near expiration.
This convergence has happened each expiration for the last 15 years (see https://www.homepricefutures.com/posts/s-p-cme-case-shiller-futures-approach-15th-anniversary) and makes intuitive sense as expiration presents an arbitrage opportunity.
That is, suppose a contract is quoted 312.0-314.0 just before settlement, and a user strongly believes that the final index value will be 310. They could sell the contract (by hitting the 312 bid) and when the index results show a 310 print, garner two points or $500 per contract (ignoring fees).
Similarly, someone else believing that the settlement index value will be 315 can buy the contract (by lifting the offer at 314) and make one point, or $250 per contract. (Again, all of this is purely an illustration of the concept of cash settlement, not advocacy of any trading.)
Note that neither user nor the contract prices are "wrong" before expiration, however the actions of traders on bids and offers should drive contract prices closer to where no arbitrage opportunity exists. (In the above case a final market of 310.0/31.5.0 would offer no such further opportunities.). That is, absent users trading contracts, a wide disperision of forecasts will likely lead to wider bid/ask spreads, while a tight consensus of expectations will tend to drive bid/ask spreads closer. For example, if a user believes that the final index will be 313.4, they could bid some price lower than that, e.g. 312.4, which would narrow the bid/ask spread,
While in past quarterly blogs I've highlighted the cash settlement notion conceptually, this cycle there is a set of third-party forecasts that can be used to illustrate the opportunity (again, hypothetically. I'm not telling people what to trade).
The table below shows the forecasts I've made as well as those from Parcl (https://www.parcl.co/) a digital coin company with growing open interest from a base of international traders. While many of my/HPHF/ forecasts are inside the bid/ask spread on the 10 expiring regional CME contracts (no surprise as many of the bids and offers are mine), many of the Parcl forecasts fall outside Friday's bid/ask quotes.
In theory (again not offering advice) if users embraced the Parcl forecasts they could take the action in the column labeled "Parcl Action" and "IF" (!!!) the index values posted Tuesday were as Parcl forecast, the users would see the gains (before any fees) listed in that column (assuming only one lot traded in each region.
To take the most extreme example, a user expecting the SFR index to be 347.66 could buy the Feb '24 contract at 340 and "IF" the index posted at 347.6 earn 7.66 points per contract (at $250/contract) or $1915.
While convergence tends to erode arbitrage opportunities, the Case Shiller indices often fall outside the final bid/ask range on some number of contracts. For example, last quarter the actual index was above the offered side for 9 of the 11 expirations. (see https://www.homepricefutures.com/posts/cme-futures-higher-post-tuesday-case-shiller-updates). On the other hand for the May 2023 expiration, the contracts bracketed the actual Case Shiller index in 9 of the 11 markets. (see https://www.homepricefutures.com/posts/may-31-case-shiller-index-updates-v-cme-prices). I only recall a handful of times where the contract prices actually bracketed the expiration-day index for all 11 CME contracts.
The missing link to having convergence work every time is the thinness of trading in these contracts, bias I my have in my forecasts (which impact my quotes), and/or any open positions I might have. For example, (again in theory) I could be offering WDC below where I expect the index to post, to try and offload a position. Having greater depth to the quotes -backed by a fuller set of users - would tend to reduce any such bias.
I am happy to discuss last-day trading situations, but absent that, will see you tomorrow.
Thanks, John
#homeprices #realestate