The way that I present hedges on cities not referenced by CME Case Shiller contracts has continued to evolve, so I wanted to post a new (2022) blog to highlight the information, and to review my latest format. My template for hedging any of these 40 cities is HPHF Ratio Agreements ("RAs"), hence this piece on how RAs might be interpreted for hedging decisions.
I've divided the top 50 cities into three categories: the 10 cities that are referenced by CME Case Shiller futures (where I continue to make markets, and where live quotes are available from third-party vendors), the second 10 Case Shiller cities (the "other cities" in the Case Shiller 20-city index), where I'll show RA's using Case Shiller indices for both the numerator and denominator, and 30 other large cities where the numerator is the Freddie Mac NSA. This last 30 cities are the focus of this blog, although Ratio Agreements could be applied referencing any city. (See the Resources page for indications on several of the cities. I've dated the most recent updates which have links to graphs of either the futures, or the Ratio Agreements similar to those shown below. To the extent there is no date (or no link) I'll get around to putting first quotes in some of those cities as inquiries come in, or if there is news about any of the cities.)
The illustration below has two graphs -one for Ratio Agreements, and one for the regional index. Those graphs sandwich the relevant information for one to analyze an RA.^1
The top graph shows the history of the regional index value^2 divided by the Case Shiller 10-city index.^3 The year-end values (released in February) are highlighted in red to reduce the impact of seasonality. (Recall that I'm using the Case Shiller 10-city index in the denominator as there are futures on that index. This will allow users to combine RAs with futures, in amounts such that one can create -over a range - outright regional index exposures.)
Rising ratios (such as shown here) indicate that the regional index has been outperforming the Case Shiller 10-city index on a relative basis, while a declining ratio means that the 10-city index has out-performed the region. (BTW -Within the 50 cities, the "strongest" city over the last five years has been Phoenix, while the lowest home price gains have been in Baltimore.)
The blue triangle/red square are the implicit bids and offers (0.875 and 0.895 from the middle of the table) on the index at some point in time in the future (in this case for month-end February 2023). However the RAs are structured as in-the-money puts and calls at strikes represented by the dotted lines. (See the HPHF page for key details, to include any KYC/AML suitability documentation that would need to be filled out before any agreement, and a discussion of how this format is designed to reduce counterparty risk). For example, someone looking to buy the ratio could act on the offered side of the Call at the 0.075 ask price. (That is the 0.895 "offer" minus the 0.82 floor). A seller could act on the offered side of the Put at 0.075 (in this case the 0.95 strike minus the 0.875 bid price). ^4
As noted above, the strikes, floors, quotes all reference the information in the middle table.
In addition, the table shows how far above/below the cap and floor are (on a percentage basis) from the implicit mid-market value. The idea here is to give comfort that the floor and strike are far enough apart such that they are unlikely to be hit. (Longer expirations would have to have wider floors vs caps to address the greater uncertainty that comes with longer-dated exposures. Cities that have had more volatile ratios -e.g. Oklahoma City and Memphis) might also merit a bigger difference between the floor and cap).
Further, the implied changes to the ratio (forward price divided by year-end values) are shown to convey whether the RAs are priced consistent with the regional index outperforming, by how much, and for both the bid and ask. In this example, I'm willing to buy the ratio at a level consistent with the Raleigh Freddie Mac index outperforming the Case Shiller 10-city index by 3.79% or to sell it outperforming by 4.96% between now and the release of the Case Shiller index in Feb 2023. Anyone with views outside that range might want to take a look. Note that both the implied gains, relative to the 10-city index are both positive. That is, the debate is whether Raleigh will outperform the 10-city index through Feb 2023, but by how much.
Finally, I've added the out-performance priced in by the regional index to the absolute performance priced into the Case Shiller 10-city index for Feb 2023. For example, the HCIG23 ^5 contract was quoted 322/330 on the date I constructed this example. The 322 bid represents an 8.12% premium over the year-end index (of 297.81). Multiplying the outperformance of the regional index priced into the RA (1.037) times the absolute performance of the 10-city index (1.082) gives an implied outright bid for Raleigh that is up 12.22% from year-end. (Since I started this draft the HCIG23 market has tightened to 325/329 so the mid-market value is one point higher to 327.
However to get RAs started, and to steer volume toward the CME, I've recalculated the gains assuming a mid-market value for the 10-city index futures (using 326). That is, I'm trying to facilitate some amount of RA's by being willing to buy (or sell) 10-city index futures at mid-market levels.
Using the higher gains (326 vs. 322) of the 10-city index futures, produces a narrower bid/ask spread on the implied gains for the Raleigh index of +13.61% vs 14.90% ( vs the 12.22%/16.31% if one just hit the 322 HCIG23 bid, or lifted the 330 HCIG23 offer). Those gains can then translated into gains in the Raleigh year-end index (of 251.08) to produce implied forward index values of 285.25/288.48.
Those prices are shown on the bottom graph that has the history of the Raleigh index.
Net, I hope to "stir the pot" with posts on any of the 50 largest cities.
Here's are examples of Ratio Agreements I've recently posted to the Resources page (some of which have not been fully converted to the this new format).
Baltimore -the most bearish relative outlook.
Phoenix -The most bullish outlook
While I'm happy to take inquiries on these cities, I'm likely to be even more enthusiastic to inquiries from readers on cities that they are looking to hedge (long or short).
Please feel free to contact me if you have any questions about this blog, have any cities that you'd like to hedge, or if you'd just like to learn more about how home price index derivatives can be used in hedging strategies.
Thanks, John
Footnotes:
^1 I decided not to superimpose the Index history in the same graph as the history of the ratio, as a) it gets busy with so much to show for Feb 2023 expiration, and b) the graphs will get busier should the template get filled out with quotes (and different floors/caps) for 2024 and 2025.
^2 I'm using the Freddie Mac NSA indices.
^3 Note that these indices have different release dates. The ratio (and RAs) are calculated on the Freddie Mac index released around the first of the month, divided by the Case Shiller index released on the last Tuesday of the same month).
^4 The user could also leave an order with me at a different level, or for more notional value that I'd care to offer. However, there is no exchange where one can leave GTC orders to be automatically exercised.
^5 Some platforms refer to the 10-city index as HCI, some as CUS, and Bloomberg may even have other naming conventions.