I've recently been getting a lot of inquiries from readers looking to protect against a fall in home prices. While the CME no longer posts options, I've got a solution.
Using the HPHF platform, options can be created by reducing strikes and floor that mimic a collated option.
The diagram below is for a put on the HCI (10-city index) with a strike at 210 and a floor of 190, on the Feb '21 contract. That is, the put buyer would buy a put that pays out 1:1 on values that the index settles below 210, with a maximum payout of 20 points, for any index value below 190. The "put writer" would buy an asset (a call) that pays out 1:1 on index values above 190 with a maximum payout of 20 points at values above 210. (In a one-off transaction I would be the "put writer"/ call buyer.) The combination of the put and call purchases would total the 20 point exposure. For example, if the put buyer paid 6 points (hypothetically) the call buyer would have to pay 14 points.
Key to this concept is that strikes, floors, expirations, notional amounts, and reference indices, can all be negotiated. The "only" (air quotes) challenge is arriving at the put premium.
Options on indices that have CME Case Shiller futures might be easier to construct as there is more transparent price discovery on forward contracts, and what might be the "at the money" strike. ^1 The existence of futures contracts will also allow either side to hedge options exposures. That is, a put buyer might be able to lock in gains should contract prices fall below the strike, while the "put writer" might "delta-hedge".
However, key to this approach is that this format can be employed on other indices. I've had recent inquiries on Cleveland, Dallas, Seattle and Salt Lake. This type of HPHF agreement can be constructed on all four (using Case Shiller indices on the first three, and Freddie Mac NSA indices on the fourth).
While forward markets don't exist on any of these four indices, the HPHF Relative Performance Agreements that I introduced last week might help guide where forward prices might clear. (Again, note that forward prices reflect levels that parties are willing to exchange risk, not forward expectations. See my April 13th blog for further discussion).
That is, if the HCI (10-city) Feb '21 contract is quoted 207.0/214.0, or 89.4%/92.4% of year-end 2019 levels, and if Seattle RP Agreements for Feb '21 were +2.0%/+4.0% (hypothetically) then Seattle G21 risk might clear at 91.4%/ 96.4%. Again, if in the existence of an HCI quotes at 91% of spot, people believe that Seattle risk should clear at 100% of spot, they are in effect saying that Seattle relative performance is much stronger than +2%/4% and might want to consider an RP agreement.
For all agreements, "points" will need to be translated into dollars. For example, if someone wanted to hedge $500k of notional value, on a index with spot value of 232 (so HCI 10-city index), and the put was written with a 210 strike (~90.5% of spot) and 190 floor (~82% of spot), then the maximum final payout of 20 points would be 8.2% of the notional value, or $42,500. Using the above example, 6 points (or ~2.5% of notional) would be ~$12,500 -the premium from the buyer, while the put writer would post the balance ~$29,500) (I've rounded here to tie numbers out.)
I like this concept as it addresses a need shared by many. There are no CME options, the amount of potential exposures are known upfront (not the case for a futures/forward long or short), and the upfront payments are small compared to the upfront margins some brokers charge for margin.
On the other hand, as presented, most of the inquiries I've received received are from users looking to buy protection, so (as before) this market will need to find "put writers" (call buyers) to grow beyond a few $mm notional hedged value.
Feel free to contact me if you have any questions on this blog, options strategies, or any issues related to hedging using home price index derivatives.
^1 - Note that the parties don't have to precisely agree on where the futures would clear to enter this kind of transaction. However, the presence of futures prices will drive my pricing of the options.