I continue to believe that HPHF Ratio Agreements might be the best, publicly available platform for either expressing a view on home price expectations, or hedging (long or short), for a large range of cities. That is, while there are ten regional Case Shiller futures traded on the CME, Ratio Agreements might be a useful way to try and hedge exposure to dozens of other cities both to Relative Performance, and (when used with CME Futures) vs. Outright price moves.
Let me use Nashville as an example, and to illustrate new features on my Ratio Agreement template, and to list key features.
A -Relative Performance Hedging
1- Note (the black line) that the ratio of the Nashville home price index^1 divided by a more national index^2 has been strongly increasing for the last few years. That is, the gains in Nashville have been higher than those in more national index.
2- Nashville home prices have been highly correlated with national price moves over various timeframes (see table to the right). That means that someone with Nashville exposures could've sold some amount (69% in hindsight) of CME 10-city index futures, and hedged moves in the Nashville home price index. Of course, such correlations are only obvious in hindsight, have not held when Nashville prices have sharply diverged from National trends (e.g. 2013), and may not hold in the future should preferences for where to live change (e.g. shift to remote work, affordability concerns). Ratio Agreements might be the tool to use if one thinks that past relationships will change.
3- The "implied" bid for the forward ratio is 1.105 (or 4.19% above the Feb 2021 index^3), while the "implied" offer is 1.125 (or 6.08% of the Feb 2021 Index). That is, the quotes are consistent with Nashville continuing to out-perform the 10-city index over the forward time frame (here through Feb 2023). As such, the debate is not whether Nashville will out-perform, but by how much. I'm willing to "buy" that Nashville will outperform the 10-city index by 4.19%, or to "sell" Nashville at 6.08% (< 2% bid/ask spread). (Nashville realtors/ homeowners/ future buyers, take note!).
As an aside, there are cities (e.g. Chicago, Minneapolis) where the ratios are heading lower. (After all, some cities have to perform worse than average.) In cities with declining ratios, the math works out that gains in those cities will be smaller than those in the CS 10-city index.
4- Notional values can be negotiated to back into the value of an .01 change in the ratio. For example, in an Agreement to hedge $100,000 of Nashville home price index exposure, a value of $897/.01 would work. (That is, a change from 1.115 to 1.125 would be a 0.897% change. A 1.00% change from 1.115 to 1.12615 would be $897/per point * .0115 points or $1000), which equals 1% of the $100,000 notional. Alternatively, different values can be negotiated for the value of an .01, to back into different notional amounts.
5- Since HPHF Ratio Agreements are OTC arrangements, I've introduced caps and floors on payouts (more on how below). That way counterparties know the maximum amount they stand to lose should the ratio move away from them. For example, in the case below, the maximum payout would be the difference between the cap (1.18 and the floor 1.05) times the value of each .01. In the above example of $100,000 notional exposure, the maximum payout would be .13 times $897/.01 or $11,661 to the "long" should the final ratio be 1.18 or higher, or the same amount to the "short", should the ratio end up at 1.050 or lower. (Elaborating further, I don't intend to have HPHF offer protection against large moves in relative tail risk (e.g. that the Nashville index value doubles in the next year, while the more national index is flat, or worse that California falls in the ocean on an earthquake. Some risks are best left for governments to offer as a social policy).
6- To collateralize the final payout (thus trying to address counterparty concerns) HPHF Ratio Agreements are structured as deep in-the-money calls and puts. Someone wanting to go the Ratio Agreement would buy a call (from HPHF) with a strike (floor) of 1.05 and a cap of 1.18, while someone looking to go short the ratio would buy a mirror-image put (i.e. a strike of 1.18 and a cap of 1.05.)^4 Since I would "sell" the ratio at 1.125, the call buyer would pay 0.075 points (1.125 minus 1.05) or $6727.50 (in the above example that uses $897/ .01), or the put buyer would pay 0.075 points (1.18 strike minus 1.105 implied bid) or $6727.50. That is, a user can take a $100,000 notional exposure (in this case) with the buy of a put or call for < $7,000. To encourage activity, I'd be open to being on the other side of such inquires. That is, if someone bought a call for 0.075 points, I'd buy the offsetting put (from HPHF) for 0.055 points. The proceeds (to HPHF) from the two agreements would 0.13 points, sufficient to collateralize the full range of payouts.
7- Note that these options are European-style so that they can only be exercised at expiration (and will be done so automatically). (I intend to be open to entering offsetting agreements in the future, and/or intend to share when there are others looking to add/reduce exposure).
8- The Agreements are structured for ~ one year exposure a) to get the concept of Ratio Agreements up and running, b) to focus users on a single maturity, and c) to minimize the upfront premiums for early users.
9- Option strikes can be negotiated, but should be a function of a) time to expiration, and b) historical volatility in the ratio. That is, on point "a", longer expirations will (in time) have wider bands (as uncertainty rises with time). On "b" Nashville is one of many cities where the home price index has been highly correlated with the Case Shiller 10-citty index. As such, the historical changes in the ratio (of the two indices) has been very stable. I've proposed boundaries that reflect outlier views (e.g. that Nashville will perform worse than National, or that Nashville will out-perform by > 10%). The boundaries can be expanded, but will result in ever-larger option premiums. That is, there's a tradeoff between (in extreme) doubling the boundaries, while dramatically increasing the option premiums. This program is intended to offer protection against modest ranges in the Ratios, but not ones that are multiples of prior years.
Importantly, the boundaries are (designed) to be wider that any previous one-year move in the ratio. By contrast, setting boundaries on a range of moves for the Nashville index, would require dramatically wider boundaries.
10- Potential counterparties will need to fill out documentation (see HPHF website) as HPHF needs to be sensitive to AML/KYC issues, even though all potential users would be counterparties, not clients.
B -Outright Hedging
A key reason for using the Case Shiller 10-city index in the denominator for Ratio Agreements, is that there is a CME contract on that 10-city index. That means that someone combining a matched notional amount^5 of Ratio Agreements with offsetting CME 10-city index futures, can achieve an outright long or short exposure on the regional index. ^6 For example, someone bullish on Nashville could be long a Ratio Agreement call (in effect, long Nashville relative to a short in the 10-city index) and then long same notional amount of the CME 10-city index futures. They would see the Case Shiller index performances cancel each other out, leaving one net long the notional amount of Nashville.^6 The reverse would be true for someone who is bearish, as they could combine a Ratio Agreement Put with a short position in the CME futures.
Note that, the implied forward level for one-year forward Nashville would include the implied gains on the CME contract, plus the relative pricing of Nashville vs that index. As shown below, combinations of Nashville Ratio Agreements and CME 10-city index futures, translate into implied outright gains in the Nashville index for 2022 of 8.65-11.40%. ^7 (Note, that the implied outright performance levels might be tighter, as I'd expect to be open to trading inside quoted CME bid/ask spreads to facilitate an HPHF Ratio Agreement).
Note that this second approach requires users to qualify for, and to open, a futures trading account with an FCM (Futures Commission Merchant). Please review my "how to start trading home price futures" blog to learn more about the first steps.
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Net, one can set up Relative Performance arrangements using HPHF Ratio Agreements, or Absolute Performance exposures when combined with CME 10-city index futures. While there are >300 cities that have Freddie Mac home price indices, I'd like to start by limiting activity to the top 50. Several (e.g. Phoenix, Reno, Boise) have ratios that have been quite volatile and, as such, I'd propose slightly wider boundaries.
I'd encourage feedback on this concept and would love to hear from readers as to which areas they'd like to see Ratio Agreements quoted. My hope is that, in time, there can be bi-weekly(?) auctions of exposure to groups of cities, but for now, I'm open to taking limited exposure, on either side, to many of these cities.
Feel free to contact me with questions on any city, and the amount (and direction) you'd like to hedge.
Thanks, John
Footnotes
1 -Freddie Mac NSA index. Link here.
2- Case Shiller 10-city index. Both are updated monthly.
3- I use "implied" as, described later, actual bids and offers are on calls and puts.
4- Note no one can short a ratio (and capture proceeds). One can only be long a call or a put. Unwinding would involve selling that exposure, or buying an offsetting put/call.
5- See table that notional value of 1 CME 10-city index contract is ~$78,000
6- Note that the hedge breaks down should the ratio exceed either boundary condition.
7- I'm using the February release of each index as both refer to the period ending 12/31/22.