The graphs are of 1) the Nov 2007 CUS contract, 2) the Nov 2008 contract, and 3) the Case-Shiller CUS index over time. Closing prices on the CME contracts are noted by the lighter shaded lines. Actual trades are noted with darker squares.
A few observations:
1) (A simple one) The CME contracts trade daily, while the Case-Shiller index is only released monthly -hence, the infrequent, step-function in Case-Shiller numbers.
2) Note that trades tend to result in changes to prior closes. (See Basics blog on Closing for more details.) Note how in the Nov 2008 series that the closing price was unchanged at 183.8 from Feb 3-26 until a trade took place at 176, which then resulted in the subsequent lower close. (Again, getting back to the point that I’ve harped on that “Closes” may not necessarily represent current sentiment.)
3) Note how prices on both series converged toward the CS index that was released in the month the contract expired. As prices for the contract must be the same as the index at expiration any large variance from the expected CS index can be arbitraged. As the CS index is a lagging, moving-average index, it is extremely unlikely that the CS index will dramatically jump in any month. This means that longs and/or shorts have an ever clearer picture of the eventual value of their outstanding positions.
4) As such, an option for longs/ shorts is to hold positions to expiration. While this may dampen trading (bad for me as a market maker) it gives increased confidence to those thinking about entering new positions that they won’t be subject to wide bid-asked spreads if they hold the position to maturity. This increased confidence should give more people comfort that they can use these contracts as longer-term hedges (or insurance) against long/underweight positions (good for me as a market maker.)
5) Finally, note that early in 2008 the Nov 2008 contracts traded to pronounced discounts to the then spot Case-Shiller index. Did the contracts incorporate a consensus view that home prices had further to fall? Were sellers so desparate to find a hedge to other real-estate related exposurses that they oversold the contracts? Were the longs just being adequately compensated for providing a service (protection against a melt-down in home prices) that required a sufficient rate of return? All of these questions are the themes of academic studies that should be reviewed.