While there are ten regional Case Shiller home price index contracts traded on the CME, many cities are not represented. Users have asked me over the years how to hedge exposure to Phoenix, Seattle, Austin, Salt Lake and other cities. The performance of many of these regions has been highly correlated with the HCI (10-city) index, so, as start, one could pick up 60-70% of the regional performance with a properly weighted ratio of CME 10-city index contracts.
For example, the YOY performance of the MNX^1 index has closely tracked that of the HCI index for almost ten years.
However, users have expressed interest in a hedge that might track a regional index more closely. In response to those inquiries I offered home price index agreements via my HPHF (Home Price Hedging Fund) platform. While those agreements "worked", I feel that I've now found a better way (that I've described in more detail in the marketing material on the HPHF website page), that takes advantage of these strong correlations.
Let me illustrate by using Minneapolis as an example.
There are two key sections (questions to address):
*How to hedge Minneapolis more precisely, and
* How to approach pricing.
As to the first section, some background on my thinking process might help.
Recall that I had originally proposed OTC agreements on the forward price of a Minneapolis index. That is, if the Minneapolis Case Shiller index from Dec 2019 (released in Feb 2020) is 178.52, then two months ago, I might have been negotiating a forward agreement for Feb '21 at 183.9 (+3% over year-end value). For such an agreement to be fully collateralized, given market volatility at the time, I might have suggested that the two HPHF components be a call struck at 165 with a 205 cap, and a put struck at 205 with a 165 floor. The premium from each party (about 10% of notional value) would collateralize price outcomes between the floor and cap.
However, three challenges arose (that the new method addresses):
First, markets became a lot more volatile. A +/- 10% move on certain cites (e.g. Las Vegas) would have hit a 10% boundary in the weeks after a February trade. Such agreements trading close to a cap or floor then shift from being forward trades to more one-sided options. Also fungibility becomes a problem as strikes, caps and floors all need to be adjusted with the market move.
Second, users expressed an interest in longer-term trades (e.g. 2-3 years). While a +/-10% set of boundaries might have worked for one-year trades in quiet markets, wider boundaries became necessary. However, the wider the boundaries the higher the option premiums required, limiting the number of trades that can be done.
Third, facing a wave of hedgers, if I ended up being the long, I'd have multiple, highly correlated long exposure. I could hedge that by placing shorts in the CME Futures (trying to take advantage of the correlations), but then I'd still have to margin each side, and have multiple long exposures where I'd need to find another buyer, specific to that regional index, to unwind.
My new approach to hedging Minneapolis is getting users to recognize that (for wide price ranges), regional index performance could also be separated into two components:
I'm dividing an outright regional agreement into two parts: 1) the Absolute Price Return that can be captured by the performance of a CME 10-city contract, and 2) the Relative Performance of the index to be hedged vs. the CME contract in an HPHF agreement. Absolute price exposures can be channeled through the CME with much less of an upfront payment (so they can take care of margins^2 while offering very wide price volatility) while the collateral required to post OTC swap agreements is much lower IF(!!!) the regional index is correlated with the 10-city index.
Fortunately that's (been)^3 the case for the "other ten" public Case Shiller home prices indices (see below) as well as many other larger regions referenced by Freddie Mac NSA indices (not shown).
Key benefits to this approach (for both users and market maker) include:
*Absolute price risk is channeled to a single, more liquid, public market. Ten regional index hedges will now create ten trades on CME futures, where there is a much bigger audience, rather than me finding (or positioning) ten outright long exposures, this also lets users separate, or unwind) the timing of the absolute part of the price risk, from the less volatile Relative Performance agreement.
* If regional contracts are highly correlated with the CME 10-city index, then most of the price variation in the regional contract will come from moves in the 10-city index. The Relative Performance moves will be smaller. (For example, if two series each have a 4% standard deviation, and are correlated 50%, the covariance is 2%. ) As such, small boundaries can be used.
For example, the MNX/HCI ratio has been fairly stable for the last few years. ^4 I'd collateralize a first trade with a range from 0.70 to 0.85.
Net, someone looking to hedge the price risk of the Minneapolis index, can do so, by: 1) having a FCM account open where they can sell Case Shiller 10-city index contracts, and 2) entering a Relative Performance agreement on the HPHF platform.
Please read the HPHF marketing material if you have questions, and please review disclosure language.
I'd expect questions about how this combination works. Please feel free to contact me if you have any question.
Now, let's turn to the second price -the pricing and logistics of the Relative Performance Agreement.
If the ratio of MNX/HCI at year-end was 0.771, and, if (purely for example), I believed that MNX and HCI would have the same performance in 2020 (regardless of the direction of the market), then I'd expect the ratio would be the same next year-end. To quote markets, i might be willing to buy MNX at a price that generated a ratio of a 2% discount from 0.771, or 0.756. Conversely, I might take the other side of the agreement with prices corresponding to 0.787 (a 2% premium).
Thus if I could buy or sell the HCIG21 market at 203.5 (from the person looking to do this new approach), my price quote for MNXG21 would be 153.78 bid/ 160.06 offer.^5
A person doing this combination (i.e. hedging MNX() would be short HCI at 203.5, but long the performance of HCI (from 203.5) vs short the performance of MNX (from 153.78) through expiration, when the then-current index numbers would be used to settle the agreement.^6 As with the original HPHF agreements their exposure would be bounded (e.g. +/- 8*% relative performance), their exposure would be formatted as options, and the funding of the option trades would collateralize a wide range of likely exposures. (Importantly for capital purposes, the boundaries could be much narrower than on a outright regional agreement. The two HCI exposures would net out, leaving the MNX exposure.
I'd be open to pursuing this notion with any index that: 1) has had a >50% correlation with the Case Shiller 10-city index, and 2) where I believe that correlation will continue (so no Las Vegas agreements).
Again, I expect more questions at this point, so please consider this a first step toward understanding this approach. Please review my website https://www.homepricefutures.com/hphf for details, or feel free to contact me if you have any questions, or if you have an index you'd like to discuss.
^1 MNX here is the symbol for the Minneapolis Case Shiller index.
^2 Having the ability to open a futures contract may also provide some comfort on a user's ability to understand derivatives.
^3 Correlations shown here are for year-on-year price changes (of the most recent, possibly updated, index values, from Jan 2011 to the March 2020 release). There are, of course that no historical correlation continues going forward.
^4 Focus on dots in the graph as the represent year-end values. The oscillations in the ratio represent difference in the impact of seasonality on each of the two indices.
^5 This is purely an example as, for instance, I might believe that region will do better (or worse) than HCI and will price that into my end ratio.
^6 The notional of the swap has to equal the notional of the CME futures contract -one downside of this approach. Note also, that the performance would be subject to boundaries.