I'm back from a spectacular vacation (Croatia, Italy) and, having reviewed changes to market sentiment, want to dive into a new way of looking at forward prices.^1
Basically, I've incorporated my prior ratio analysis (price of regional index/ 10-city index) and forward prices, to have live updates to Ratio Agreements to (to start with) the ten components of the CS 10-city index. My sense is that in showing forward markets this way users might get a better sense of the possible magnitude of gains/losses forward markets imply (at least vs the CS 10-city index). This is important in pricing levels where risk clears (as opposed to expectations) if you believe (as I do) that the CS 10-city index markets are the best indicator of risk-clearing levels. That is, this gives more structure/discipline to pricing of regional risk.
This also supports my notion that the biggest contributor to changes in most regional contracts is movements in the 10-city index contracts (with the past exception of Miami where the ratio has exploded, and with the forward exception of SFR). As such, users looking to take exposure to regional contracts might consider first taking the absolute market exposure using the 10-city index contracts (that trade with tighter bid/ask), thus covering big moves in the market, before adding regional to 10-city index exposure (available via IC spreads on these ten regions, and with Ratio Agreements for other regions). In some cases the combination of these two trades (outright 10-city index plus an IC quote) might be a tighter bid/ask spread than an outright regional trade.
As illustrated below, one can see regions (e.g. CHI) where regions have been underperforming the CS 10-city index, and others (e.g. DEN) where the region has been outperforming.
What I've added are the quotes from the Feb '23 (G23) and Feb '24 (G24) contracts to give a sense of whether those trends will continue (as in MIA and NYM) or reverse (as in LAX and SFR. The net is, that if the CS 10-city G23 market is priced to clear at a 6% discount to spot, then (in my approach, given the challenges in SFR), the SFR market should clear at an even bigger discount (in this case 4-5% of a bigger discount).
Further, the graphs reflect that as contracts extend, the bid/ask spreads widen, as there is more uncertainty a) of the level of the CS 10-city index, and b) of the forward performance of the regional contract vs the 10-city index contract.
By having regional contract prices composed of a combination of 10-city index clearing levels and intercity spread ("IC") quotes (which can be translated into how much a region will out-/under-perform, I'm able to quote more contracts taking less risk.
Of course anyone can bid/offer the outright regional contracts, or intercity spreads, inside my levels. My goal is not to do every trade, but to set reasonable boundaries on regional quotes, that move as the 10-city index contracts move.
I'm open to trading on any of these levels, as they tie to where I'm already quoting IC spreads.
The added value will come next when I take this approach and extend it first to the ten other components in the CS 20-city index, and then to other cities (see my August 4th blog for an example).
Feel free to contact me here if you have any questions about this blog (or to sign up for future blogs), would like to share hedging ideas on any top 50 city, or just want to learn more about how home price derivatives might be used in hedging strategies.
Thanks, John
^1 I see from the CME that one HCIG23 traded at 299.0 while I was away.