Risk Markets And Politics

Thursday, November 10, 2005

Cold Spots

Cold spots are a staple of haunted house lore. If one takes reflexivity seriously, one might be concerned about the effect of the new CME housing futures, which are due to start trading in the second quarter of next year. They will apparently be based on the Case-Shiller Indexes®, but how often will the indices be updated? Aside from increased volatility, what might happen with a discontinuous "spot" price?

CME CEO Craig Donohue touts, "Even as the Federal Reserve valued the U.S. residential real estate market at nearly $19 trillion in 2004, there is presently no liquid market or efficient means of hedging real estate [...]" We didn't need to hear this to realize that there is going to be massive selling pressure by hedgers, and the more infrequently the spot price is updated, the more the futures will tend to drift lower under this weight. This should be a good opportunity for speculators, but they may be less willing to bid without fresh spot prices, especially in a downtrend. What will happen if we start to see red numbers under a "Housing" bug on CNBC day in and out?

Lastly, this does not bode well for our friends at Hedgestreet, but you have to hand it to the CME; they seem vastly more interested in innovation (and transparency) than another U.S. mercantile exchange that comes to mind.

11/11/05 Update: The CSW website contains some details on the current incarnation of the Case Shiller Indexes. I say "current" because I don't think the market will tolerate this lack of frequency in updates:

CSW produces index updates every quarter at many geographic levels - including by U.S. Census Division, by State, by Metropolitan Statistical Area (MSA), by County, and by ZIP Code.

Nor this lack of transparency:

CSW calculates the CSIs utilizing both published and unpublished index calculation techniques developed throughout the years by Case, Shiller, and CSW's research staff

I am sure these issues are currently being dealt with.
Interestingly, CSW has a related Home Price Forecast model:

The HPFs blend CSW's home price trend and econometric analyses with the company's home price forecasting technology for residential real estate markets throughout the U.S. HPFs reflect an objective outlook for the coming year. [...] CSW has been publishing a sample of its Home Price Forecasts (for 23 metropolitan areas selected by The Wall Street Journal) more than five years. The majority of the time, these CSW Home Price Forecasts have been within two percentage points of the actual market change that unfolds for the forecasted period.

As the CSIs become more influential, one would expect these forecasts to take on more importance as well. They could also be used to mitigate any "spot" frequency problem.

Now, with a legislation-linked future we of course have no spot prices before settlement, but in those cases we can watch the legislative proceedings and ask legislators questions, thereby collecting information that will give us a good idea of the probability of a bill's passage.


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