Home Price Indices Futures

Real Estate Issues, Spring 2008 by Tokic, Damir, Tokic, Stijepko

CAN CME HOUSING FUTURES BE USED AS AN ARBITRAGE TOOL?

An arbitrager in CME housing futures would have to offset the short (long) position in housing futures by buying (selling) a real house or houses. It is an unlikely scenario because purchasing or selling a house takes time and requires significant fees, from closing costs to commissions. Further, individual home prices depend on other home-specific variables, in addition to general macroeconomic variables, that affect a housing index. Consequently, it would be extremely difficult to arbitrage a housing index with a real house unless a large portfolio of houses is constructed, which is impossible because of high transaction costs.

FUTURES AS SPECULATIVE TOOLS

The interaction between consumers and producers hedging their risks sets the price in futures markets. A class of market participants called speculators tries to anticipate price changes resulting in supply/demand shifts in, for example, copper markets, and consequently tries to profit by betting on price direction by taking a one-directional position in the futures markets. For example, a speculator would open a long position in copper futures if copper consumers anticipate a shortage of copper, which in turn, would trigger significant hedging. As a result, the price of copper would rise until the supply met the demand, and a speculator would make a significant profit.

CAN CME HOUSING FUTURES BE USED FOR SPECULATION?

A speculator anticipating rising inventories of unsold homes and falling demand could profit by shorting CME housing futures. Given the current situation of falling housing starts, falling building permits, falling new and existing home sales, rising inventories, significantly higher short-term rates, and expected adjustment of super-low ARMs from 2003-2005, it seems a sure bet that home prices would significantly decline in 2007.

However, speculators need liquid markets to exit their bets. Because of a lack of participation of hedgers and arbitragers, CME housing futures do not offer the necessary liquidity to speculate. In addition to low volumes, the bid-ask spread on CME housing futures contracts is too large for speculators to profit. As a result, CME housing futures are not likely to attract significant speculation.

SO, WHAT'S BEHIND S&P/CASE-SCHILLER� HOME PRICE INDICES FUTURES?

CME housing futures are not likely to attract hedgers, arbitragers or speculators. So what is the justification of housing futures trading on the CME? One has to understand the importance of U.S. housing to global economic and political situations. Since the dot-com bubble burst in 2000, the housing industry has carried the U.S. economy with significant jobs creation in construction, mortgage finance and other housing-related industries. In addition, rising home values have significantly boosted consumption as a result of home equity extraction. This has supported growth overseas where goods consumed in the U.S. are produced.

A sudden and sharp drop in U.S. home values is likely to cause a worldwide recession because of the resulting drop in U.S. consumption. In addition, a loss of housing and housing-related jobs would create a significant rise in U.S. unemployment, further exacerbating a slowdown in consumption.