Thursday, April 13, 2006

Betting the House (Index)



Standard & Poor’s Corp. recently announced it will be carrying new indices that track housing prices in 10 major metropolitan cities and a composite national index, all based upon techniques developed by economics professors Karl E. Case and Robert L. Shiller, author of Irrational Exuberance. Further, the Chicago Mercantile Exchange (CME) will begin trading futures and options based upon the housing indices. Despite being valued at over $21.6 trillion in the United States, Shiller suggests there is an underdeveloped financial market for real estate.

First, a little background--futures contracts and options are derivative securities whose value is derived from the value of other assets (house prices in this example). When an investor takes a position that benefits from the asset’s value increasing, it is called a long position, while benefiting from a decrease in value is a short position.

What does all of this mean? Well, it depends on who you are:

A homeowner thinking of selling in the next couple years--you are worried that the housing market might go sour, causing your house's value to decline. You can take a short position on the index, because it benefits if housing values decrease. If values go down, you have to sell your house for less, but your short position in the housing index makes you money.

An investor who thinks real estate is a good investment but doesn’t have the money to buy property--you want to take a long position, because as housing prices increase, so do your profits from the transaction. Conversely, if you feel real estate is overvalued, a short position could capitalize on falling prices.

The first scenario is an example of risk management and the second is speculation. Simply put, risk management means identifying a risk and taking measures to protect against unfavorable outcomes, while speculation is more like betting that an asset will gain or lose value. Critics are still divided about how successful and liquid these housing derivatives will be, but at the very least these derivatives let a wide range of people actively participate in the real estate market.

1. What reaction does Shiller have to the notion that housing derivatives will add volatility to the real estate market?

2. Suppose you want to buy a house in the next couple of years, but you don’t have enough money together yet to make a deal. You are afraid that by the time you have the money, house prices will be too expensive for you. Should you take a long or short position?

3. Suppose you own a housing construction firm. You are in the middle of building several large developments at great expense. Your biggest fear is that the demand for new housing dries up. Should you take a long or short position?

4. Considering that many people think the housing bubble may be ready to burst, do you think there will be more buyers (long positions) or sellers (short positions) of these securities?

Topics: Risk management, Housing insurance, Derivatives, Finance

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