Credit generates information about supply and demand
Property derivatives will improve transparency in the real estate market. According to Tsetsekos and Varangis (2000), an active derivatives market plays an important role in facilitating an efficient determination of prices in the underlying spot market by improving transparency on current and future prices. A successful property derivatives market may have several feedback effects on its underlying properties and indices.
Derivatives and their prices generate information about supply and demand of market participants. After the establishment of a derivatives market and due to more and better information, efficiency in the spot market can very well improve. Derivatives make nontransparent prices visible. In particular, the observed derivative prices reveal the market’s expectations. The result could be that market participants anticipate price expectations faster, and nonrandom price moves such as cyclical behavior could partly be washed out. It is important not to confuse true cycles with autocorrelation in an index that may simply arise due to the index construction method. It can be assumed that prices of physical properties adapt faster to new information if there is a derivatives market.
Median prices of home credits
The Chicago Board of Options Exchange (CBOE)’s Future Exchange (CFE) offers futures contracts that track prices nationally and regionally (North-east, South, Midwest and West) and eventually in 10 metropolitan areas as well.
CFE contracts are linked to the median price of existing home sales as tracked by the National Association of Realtors (NAR). Further, HedgeStreet allows anyone with a US$ 100 deposit and an internet connection to trade financial instruments called “housing price hedgelets” based on single-family house prices in six different cities (Chicago, Los Angeles, Miami, New York, San Diego and San Francisco). Just as the CFE contracts, the HedgeStreet hedgelets are based on indices of NAR. CBOE and HedgeStreet announced on 22 February 2006 that they collaborated on retail distribution of their contracts via joint marketing initiatives and that they would share certain technologies and hosting facilities to achieve cost and distribution synergies. The agreement also involved an equity investment by CBOE in HedgeStreet.
Moreover, the London-based International Real Estate Exchange (INREEX) intends to offer contracts tied to average home prices published by the Office of Federal Housing Enterprise Oversight (OFHEO), the agency that regulates the mortgage organizations Fannie Mae and Freddie Mac. The exchange’s trading technology allows investors to trade the national or a state index online.
The low trading volume in the contracts based on the S&P/Case–Shiller index caused Radar Logic, an analytic and data company providing a range of daily indices and analytic tools, to launch a further index family for residential property. The Residential Property Indices (RPX) represent the median transaction prices per square foot paid in one of 25 Metropolitan Statistical Areas (MSAs) on any given day. In addition, there is a national composite index, representing over US$ 10 trillion in residential properties. The RPX market targets investors that are exposed to mortgage credit or to the housing market cycles in general.
Beyond commercial property loans
Beyond commercial property, the second current initiative for property derivatives in the US considers owner-occupied residential housing. This market, estimated to be more than US$ 21 trillion, is much larger than its commercial counterpart. However, large institutions have shown little appetite to trade derivatives on residential property indices, consisting of privately owned houses. Institutional investors focus on commercial property, and do not trade residential property in volumes needed to encourage growth in a derivatives market.
Several derivative products based on a housing index have been proposed to hedge housing exposure in academic literature. To improve the possibilities to pool and share housing investment risks, Case, Shiller and Weiss (1993) propose a market in futures contracts tied to regional house price indices. Englund, Hwang and Quigley (2002) suggest that there are large potential gains from policies or instruments that would permit households to hedge their lump investments in housing. Case et al. attribute the failure of the London FOX contracts in 1991 to the public’s lack of appreciation and understanding of such markets. Whether such appreciation for housing markets now exists remains an open question.
The US market is still looking for a common benchmark. Multiple public exchanges or platforms try to promote housing derivatives for builders, developers, lenders and professional investors with large positions in real estate based on different index families. Although the platforms have many differences, they all operate in a similar way to an ordinary stock market.
