In addition to providing a platform to allow users to express outright views on the forward price of any regional contact, the CME hosts trading in Intercity Spread ("IC") contracts. These IC contracts allow traders to simultaneously buy a contract from one region (for a given expiration) while selling a contract for another region, at a (to be negotiated) point spread. The benefit to users is that this will allow them to express a view, or take an exposure, in the RELATIVE performance of one region versus another.
While IC trades can be structured for any two regions (e.g. LAX v SDG, or NYM v BOS) in practice, >99% of the IC quotes I've seen have been for one regional contract (all components of the 10-city index) to the 10-city index itself. In effect, using IC spreads with the 10-city index as one side, allows viewers to see, and traders to express a view, on which components of the 10-city index are priced to out-, or under-perform that index. Critically, these views can be constructed as market-neutral. That is, one can express a view on BOS vs HCI (10-city index) and, if correct, make money regardless of whether the market goes up or down.
To illustrate, the table below shows the IC quotes for all ten regions vs. the 10-city index contract (here labeled HCI) for the Feb '21 (G21) expiration. (Note that I have live quotes in the G23 contracts also.)
IC quotes are denominated in point spreads and require some algebra to translate into views on relative performance. For example, the bid 2.6 on the HCI v BOS line means that the bidder will buy the HCIG21 contract 2.6 points above where they'd sell the BOSG21 contract, while the seller will sell the HCI21 contract 6.8 points above where they'd buy the BOSG21 contract.^1 As such, if the HCIG21 contract trades at 235.0, the bid side would buy HCI at 235.0 versus selling BOSG21 at 232.4. The 235.0 HCI price translates into ~1.5% gain vs. the spot level of 231.55, while the BOSG21 price of 232.4 is ~3.3% above the BOS spot price of 224.87., for a net difference of -1.8%. (The same math can be applied on the IC sell side.)
With both a long and short position, the IC holder's P&L will be calculated on the settlement value of the two contracts (if held to expiration). That is, if the IC long (long HCIG21 at 235.0/short BOSG21 at 232.4) contracts settle at 236.0 and 232, the IC long would make money on both sides as HCI performed better relative to BOS, versus the entry points on the IC trade. The IC long's P&L would also be the same if the contracts settled at lower numbers, e.g. 226.0 and 222. Net (for small moves, of similarly priced indices) out-performance of HCI relative to BOS generates a profit for the IC regardless of whether the market settles higher or lower.
The difference between the two gains (i.e. 1.5% gain on HCI minus 3.3% gain on BOS) is the -1.8% relative under-performance of HCI to BOS priced into the contracts today. (Note all spreads are quoted front contract vs. back, and in these examples, the HCI contract is the front contract. As such, the net -1.8% is performance of HCI relative to BOS. Negative numbers convey that HCI is priced to under-perform the second/regional leg. From the table, that would include BOS and SDG. Positive relative percentage gains would be cases where HCI is priced too out-perform the second/regional component, as in CHI and LAV). To expand, that means that the CME market is already pricing under-performance of some regional components relative to the HCI contract. That is, you can't use CME contract to "bet" that LAV will under-perform the HCI contract. Buyers are already quoting bids that HCI will out-perform. The open question (at current quotes) is by how much will HCI out-perform LAV for the G21 settlement. The IC quotes should bracket that debate at +1.0% vs +3.0%.
While I find IC spreads incredibly useful for both expressing relative value views and for translating liquidity in one contract (HCI) into quotes on regional contracts, a big qualifier (that I hinted at above) is that the notional values of two contracts are not the same. While the 3% difference in HCI v BOS might have a small impact on smaller price moves, trading HCI vs CHI via IC spreads involves 1:1 trades with contracts of dramatically different values. As such, to make a pure play on HCI vs CHI, one might need to 16 CHI contracts vs. 10 HCI contracts (to be notionally even). In the past, I've done such trades using 10 IC contracts plus 6 extra CHI. That is, CME IC trades can still be a step toward expressing relative value moves, but there may be some conversion of point spreads into relative percentage moves (as I've done in this table) and some re-balancing needed to even the notional exposures.
My next blog will address both of these features for OTC home price index agreements on my Home Price Hedging Fund platform referencing Freddie Mac indices. Net, for HPHF agreements, users lose the features of the CME platform (e.g. elimination of counter party risk, public pricing, low margin) versus being able to express views in percentage terms (not points), on notionally equivalent amounts, on many more cities. Stay tuned.
Please feel free to contact me if you have any questions on this blog, on the use of IC spreads, or how to translate point difference into percentages, or any aspect of hedging using home price index derviatives.
Thanks, John
^1 As a first benefit, note that that means that if the HCIG21 contract were quoted 234.0-235.0, the BOSG21 contract would be offered at 232.4 (2.6 points below the HCI offer of 235.0), while the BOSG21 would be bid 227.2 (6.8 points below the HCI bid of 234.0). As such, an outright market in HCI plus a two-sided market in the BOS/HCI IC market, creates an outright market in BOS, even in the absence of outright BOS bids and offers. As a check the width of the BOS bid/ask spread will be the combination of the HCI bid/ask (here 1.0), plus the bid/ask in the IC spread (here 4.2) or 5.2 points, which is the case in the derived 227.2/ 232.4 BOSG21 market.