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EconomicsThe world according to Shiller: Hedging on real estate
Bob Shiller is on a roll. He predicted the bursting of the dot.com bubble and in 2003, long before it was common knowledge, warned of the impending housing collapse. Katie Benner of FORTUNE recently wrote about Professor Shiller, reminding readers that Bob Shiller “didn’t kill the housing market, he just predicted its demise.”
Shiller is developing new financial instruments that would help to make finance less risky and enable all of us to be better prepared for the next financial crisis, including those in the housing market. His firm, called MacroMarkets, is developing hedging tools — derivatives such as futures contracts using the S&P/Case-Shiller House Price Index as the market proxy.
Shiller’s “MacroShares” allow investors to hedge against home-price changes; if you expect rising home prices, you can purchase an “up” contract and if you expect a decline, you can get a “down” contract. If house prices rise, you enhance your returns so they’re even greater. If house prices fall, you gain on the “down” contract to offset the loss in value on your house.
Hedging is a strategy to manage risk whenever there is price and/or interest rate volatility. It dates back to the “futures contracts” of medieval Japan and “tulipmania” in Holland in the 1600s. Nowadays farmers use futures contracts to lock in prices for their commodities at the beginning of a growing season. Participants in foreign-exchange transactions minimize their risk by purchasing put options to ensure specific exchange rates at the time of transaction. Managers of stock and bond mutual funds regularly enhance their returns by purchasing call options to magnify potential gains in their returns.
So, why not consider hedging methods for housing markets?
Most households have a large majority of their wealth in their homes and are vulnerable to price changes as recent months have shown. Traditionally, the opportunity to hedge against house price declines (or in favor of house price increases) has not been considered. Perhaps it’s due to the belief that real estate prices always rise (no longer). Perhaps it stems from the feeling in the real estate community that there is no need to hedge real estate transactions (no longer). Perhaps there is a belief that hedging against real estate price declines is “anti-real estate” and those in the business who wish to prosper would never hold such feelings. I wonder.
Although some reject the notion real estate ownership is risky, there may come a time when this strategy is viewed as a normal transaction for all homeowners. (Incidentally, borrowers using fixed-rate mortgages are already hedging against future interest-rate changes: the interest rate premium paid over that charged for adjustable-rate mortgages may be viewed as the price of the option.) Watch for new developments affecting real estate in the years ahead.
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About Austin: Austin Jaffe, Ph.D. is PAR's Consulting Economist from the Smeal College of Business at Penn State University. |
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