As I noted in my update to the HPHF (Home Price Hedging Fund) marketing material, I think that OTC Relative Performance Agreements ("RP") might be an interesting way for users to express a view on one region vs. the Case Shiller 10-city index, without taking an explicit outright view on the level of forward home prices. Importantly, RP Agreements might also be a good way for users to take outright views on a region if they combine them with outright trades in the CME Case Shiller 10-city index futures.
The Agreements are quoted as to levels where HPHF (or users who provide orders) would "buy' or "sell" the performance of one index relative to the Case Shiller 10-city (HCI) index over a certain time frame.^1 My intention is to show year-end vs. year-end performance: a) to standardize and limit the number of agreements, and b) to foster debate about the relative performance during a calendar year (or set of years). For example, the quote on the BOS RP agreement says the bidder will buy the performance of the BOS index over the HCI + 2%. The offer is where the user would sell the performance of the BOS index over the HCI index +5%. Note that in both cases, each side is pricing the forward BOS index as outperforming the HCI index. The debate (the bid/ask) is just by what amount does BOS outperform.
That is if the two sides settled on +3%, if the BOS index outperformed the HCI index by 4%, the bidder would be gain 1% times the notional amount, while the seller would lose 1%. ^2
Note also, that whether BOS outperformed HCI by 4%, it doesn't matter if the BOS outright performance was -10% or +10%. The Agreements are paid out based on relative performance.
Many of the RP quotes for the Case Shiller 10-city index components (to the left side of the table) are derived from where Intercity Spread contracts are currently quoted. ^3 That is, the out-performance priced into the RP Agreements of BOS, DEN, SDG and SFR (as well as the under-performance priced into the CHI LAV and NYM agreements) are consistent with quotes on the CME contracts (both outright and IC quotes). ^4
The key benefit to RP agreements starts with the Case Shiller "other 10" -the ten other public Case Shiller indices on cities that comprise the balance of the CS 20-city index. That is, I'm not aware of any other tradable platform to hedge home price risk. (See my blog on Hedging Minneapolis for an example of how an RP Agreement might be combined with CME Futures. )
Since there are no reference contracts, the first cut on quotes on RP agreements is mine. I will write (on either side) an RP on any of the ten agreements for $50k (to start the price discovery process), and will adjust quotes after that. Note that only one of the "other 10" regions (DAX- Dallas) is quoted with a bias toward under-performing the Case Shiller 10-city index. This reflects the recent historical performance in these cities, as well as what I sense is a growing preference for "smaller" cities.
I intend to follow this up with RP agreements referencing Freddie Mac indices on other cities not mentioned here. In several (e.g. Austin, Salt Lake, Reno) I'd expect even greater amounts of forward index out-performance to be included in RP bids and offers.
Please review how HPHF Agreements work to understand how an RP Agreement would be structured, and to review disclosure and risk documents.
Please feel free to contact me to discuss Relative Performance Agreements, to share ideas on possible agreements, and/or to discuss any aspect of hedging using home price index derivatives.
Thanks, John
^1 Note that this blog describes pricing for the Feb 2023 index release (covering activity through Dec 2022). RP agreements can be structured for any year-end, publicly available index.
^2 See HPHF marketing for more details, and/or contact me.
^3 See March 20th blog for a review of intercity Spreads.
^4 Users may prefer to express RP agreements via InterCity Spread contracts. In those cases the CME would be the counterparty, and upfront cash flows (margins, not option payments) would likely be smaller. On the other hand, IC agreements are one lot by one lot, so :a) the notional amounts are not the same, and b) the notional amounts are limited to multiples of the contract notional amounts. WIth HPHF RP agreements, notional amounts are matched and can be for any amount.