On April 15th I wrote about how there are two dimensions to trading the HCI (10-city index) contracts: Absolute Price Exposure (to debate the level of prices on the Feb '21 contract, and Calendar Spreads (to debate the shape of the forward curve -out to Feb '25- on HCI contracts). (see link here). Today, I'd like to review a third dimension -how HCIG21 prices can be used to generate regional quotes.
As the CME Case Shiller markets have become more volatile, I've opted to change how I approach pricing of regional contracts. That is, instead of quoting ten absolute Feb '21 regional contracts, I've split regional price levels into combinations of the Absolute Price Risk of the overall market move (i.e. the HCIG21 contracts), with an expected Relative Price Performance of any region vs. the overall market, by using intercity spread ("IC") markets.
I've detailed how to use IC spreads in the past (see March 8th blog) but germane to current pricing, the combination of an outright HCI Feb '21 market and series of IC spreads is all that is necessary to create a set of ten regional bid/ask spreads. For example, (referring to the table below which is a few days old), the combination of a 210 offer on the HCIG21 contract plus the minus 1 bid on the HCI/BOS IC quote (where the IC buyer is willing to buy HCIG21 at 1 point below where they'd sell BOSG21) results in the 211.0 offer on BOSG21.
One can use similar arithmetic to see how other regional prices were created. Note that bid/ask spreads of the regional contracts (if generated this way) are the combination of the HCI G21 bid/ask (of 8) and the regional IC bid/ask spreads. As with calendar spreads, the more the HCIG21 can attract those looking to express absolute risk, with the result of HCIG21 becoming tighter and deeper, the better the regional markets will be.
There's nothing stopping users from entering outright bids and offers inside the quotes generated in this fashion, but at least this way, a full set of regional quotes can be created by taking the absolute risk of only one contract.
One of the benefits of this approach is that it compels users to think about Regional Relative Performance, that is, the basis for the IC quotes. Again using BOS as an example, the IC market of -1.0./3.0 (note table has columns reversed) equate to levels where the bid side (-1.0) is equivalent to buying HCI/ selling BOS/ at prices consistent with BOS outperforming HCI for 2020 by 3.4%. The offer (3.0) would be where BOS would outperform HCI by 1.5%. The difference between those two levels of relative performance (i.e. 3.4%-1.5% = 1.9%) creates a whole arena of Relative Performance markets that can be debated. (Note that the percentage differences between the regional bids and offers are fairly wide. However, if the HCI market were to trade at one price (a locked market) then the bid/ask spreads on the contracts would be the same as in the green columns.)
Similar to the outright markets, it's not sufficient that people believe BOS will outperform HCI (to trade within current bid/ask spreads), or that LAV will under perform, but by how much. Much like the discussion on calendar spreads those debates can be argued regardless of market levels.^1
Also, similar to calendar spreads, the risk to an IC position (w/ a simultaneous long and short) should be lower than either outright market, particularly, as here, if the two markets are highly correlated. Net, one should be able to trade more IC contracts than outright contracts, given a constant risk budget.
While the CME IC contracts all a way to express those views on exchange-traded contracts, this can also be done for other regions not referenced by CME contracts using my HPHF platform. (See description on Resources page of www.homepricefutures.com or link here).
My hope is that should volatility abate, regional bid/ask quotes will narrow, either as bid/ask spreads in the two component markets (HCIG21 and the ten IC markets) narrow, or as outright regional bids and offers return. in the meantime, feel free to contribute your views to either of the two component markets.
Meanwhile, feel free to contact me if you have any questions related to this blog, or any aspect of hedging with home price index derivatives.
Thanks, John
^1 Different from calendar spreads (where the notional value of each leg is about the same), on IC trades the notional value vary with contract prices.