I want to expand on my prior blog on HPHF Ratio Agreements referencing Atlanta to illustrate approaches to hedging home prices in other cities, and some new ideas. I'll use Chicago as an example, but the lessons shown here might apply to 25 other cites.
The good news for those looking to hedge Chicago exposure is that there are CME Case Shiller home price index futures for that city. However, having a regional contract is not a necessary condition. The graph below shows how correlated (from February vs. subsequent February from 2014-202) are the one-year percentage changes in index levels (~HPA) between the Case Shiller 10-city index (on the X axis) and the Case Shiller Chicago index ( on the Y axis). This correlation is similar to other very large cities, as a large portion of home prices across cities is likely driven by national trends (e.g. mortgage rates, GSE programs, and the macro-economy). In addition, some of these cities are large components of the Case Shiller 10-city index, and so are going to have to be correlated with themselves. (For example, eight of the ten regional components of the Case Shiller 10-city index have correlations with that index of >80%, however, nine of the ten "other" components of the Case Shiller 20-city index (and as such, not components of the 10-city index) have > 70% correlations with the 10-city index.)
One takeaway from this is that it might be easier for hedgers (long or short) to find someone willing to trade the absolute level of prices (using 10-city index futures) than finding another party willing to express the opposite view in a particular city. For instance, there were six times as many 10-city index futures traded last year, relative to CHI. That is, take care of the biggest moving part in home prices using the 10-city index futures, to access better liquidity.
My desire to see Ratio Agreements used, is that instead of having 11 outright price markets (or more) where one needs to find a willing counterparty to transfer versions of absolute price risk, this thinly traded market might benefit from having users focus their absolute price hedging in the one 10-city index contract. This concentration of eye-balls will bring more liquidity to that market, and tighten bid/ask spreads and increase depth.
The (relatively) bad news for Chicago homeowners is that while the correlation has been strong, the performance of Case Shiller CHI index versus the 10-city index, has been weak. The graph above shows that in all eight years, the YOY gains for Chicago were lower than that of the 10-city index (and hence fall under the red 45 degree line).
That underperformance can also be illustrated in this updated template (below) for HPHF Ratio Agreements. That is, the ratio of the Chicago index divided by the 10-city index, has been falling every year (using the red dots for February index releases).
Relative to the above, if someone looking to hedge is concerned that using the 10-city index future might not capture a regional move (i.e. that correlations break down) they might consider adding a HPHF Ratio Agreement, to a 10-city index trade, to more completely cover the risk of movements in that city. Note however, that the forward ratios might already price in a continuation in trends (similar to the relative prices in futures markets). For example, the CHI ratio in February 2021 was 0.605, but both the bid and offer on the ratios for Feb 2022 and Feb 2023 are lower. (One can back into a wide range of outcomes that would be consistent with the lower prices -e.g. 10-city unchanged and CHI -3.6%). Forward pricing of one city versus the 10-city index (or other cities) is at the heart of Ratio Agreement pricing, but the range of relative performance moves is less risky, and as a result, larger notional amounts of Ratio Agreements should be easier to trade.
On the other hand, if someone wants to make the statement that the CHI index will have about the same percentage change as the 10-city index, entering into a HPHF Ratio Agreement at a discount to last year's value, might be a way to express such a view.
(Also, as I mentioned in the prior blog, that in expressing such a view in CME futures -via an intercity spread - the notional value per lot are different between the regional and 10-city index contract, and the total notional size has to be a multiple of that of one lot. By contrast, one could enter a $100,000 CHI Ratio Agreement, or any other notional value).
Note here that I've added quotes to Feb. 2023 expirations (relative to my last blog), and have added separate (wider) boundaries for a Feb 2023 agreement. However, even the wider boundaries on a Feb 2023 agreement (equal to about 88% and 103% of spot) are much tighter than would be the boundaries on an OTC agreement.
Again, the key here is not necessarily to offer an alternative way to hedge Chicago home price risk but to prompt readers to think about what other cities they might want to hedge.
Please feel free to contact me if you have questions about this blog, have any risks (long or short) that you'd like to hedge, or if you'd just like to learn more about the use of home price index derivatives in hedging strategies.
Thanks,
John