As a market maker, I may have positions, bids or offers on any of the CME Home Price contracts. This write-up should not be construed as an offer to buy or sell, nor should it be taken as investment advice. The opinions expressed here represent my views and in no way should be construed as to represent the views of the CME, MacroMarkets, S&P or Fiserv.

June 9, 2010 – The recent MacroMarkets survey on forward home prices was a great effort, but it prompts several questions: “Ok, what do I do with this information”, “How can I take advantage of the strength of my convictions”, and importantly, “What can I advise my clients to do if they share my outlier bullish (bearish) outlook”.

There are numerous potential implications related to the relative strength of the overall economy, possible inflation expectations, and consumer confidence that might be consistent with an outlier view on forward home prices. However, there are few pure plays on how to translate such a view into a trading opportunity. ABX trading, investing in distressed loans, or picking bank and REIT stocks all have other considerations, and may involve additional expenses.

While Wall Street has a menu of OTC trading products (e.g. home price forwards, total rate-of –return swaps, and indexed-linked notes), there is one publicly traded platform that represents the purest play on forward home prices – the CME Case-Shiller Home Price futures contract. (Click Here for more information).

To quickly recap, the CME contract references the most widely quoted home price index –the S&P/ Case-Shiller Home Price index. There are contracts for both a 10-city composite index, and for each of 10 regional areas, that are quoted on a quarterly cycle out to Nov. 2011 and then at less frequent intervals out to Nov. 2014. The contracts are cash settled such that the value of the CS index at expiration is the closing settlement value for the contract. (i.e. each contract’s price converges at expiration with the index so some of the issues associated with the ABX cash/synthetic basis risk that can run for the life of the CDS, don’t exist.) Pricing is public, the CME is the counterparty to all trades (which may reduce counterparty concerns, and may make netting of trades easier than OTC trades), and margin agreements are applied to all accounts.

The first chart below shows the historical price from 2003 of the CS/Home Price indices for the 10-city Composite, NYC and LA in bold lines. The dots represent the closing prices of the CME Home Price futures contracts for settlements out to Nov. 2014 as of May 20th. One can see from the CME futures closing prices that “the market” is pricing in an L-shaped or hockey stick style recovery. One might infer that home prices, as suggested by these prices, will be essentially flat for the next few years, with a slight upward bias starting in 2012-2014.

The benefit to the CME Home Price exchange (and yes, I’ll get to the downside) is that if you don’t agree with this forecast you have a tool available to articulate a different view – that is, you can buy forward contracts if you’re more bullish, a pension fund looking to make a forward allocation to real estate, or a foreign investor looking for US-dollar denominated product in the midst of a Euro-meltdown. Alternatively you could sell longer-dated contracts if you’re more concerned about deflation, or just want to hedge your own personal exposure (e.g. a home whose value may exceed multiples of your net worth).

What’s the downside? Well, I’ve tried to be precise in highlighting that the numbers reflected in the dots in the second chart below are based on closes. Liquidity in the contracts has been very limited, open interest has declined to <100 contracts and the bid/asked spreads are often quite wide. The chart to the right takes a closer look at the NYM contract. A few notes:

• The contract price is denominated as 100* the index.
• Closing prices are a function of the last trade, or a subsequent higher bid, or a lower offer. With few trades closing prices may not change often, and may appear to be stale.
• The bid/ask spread tends to widen as you go further into the future as uncertainty grows.