Home price derivatives.(Author abstract)(Reprint)

The fast-paced appreciation of home prices in recent years made residential real estate the second-largest class of assets owned by U.S. households in 2006, comprising 34 percent of their assets (by comparison, stocks comprised 27 percent and bonds 39 percent that year), up from 24 percent in 2000. Typically, real estate holdings are also highly leveraged, so fluctuations in housing prices result in much bigger fluctuations in homeowners' net worth. If home prices decline, as some predict, homeowners may have considerable exposure to the real estate market's downside risks, yet they can do little to protect themselves from such volatility.

This is about to change. On May 16, 2006, the Chicago Mercantile Exchange began trading two new derivatives contracts, a futures contract and an option on the futures contract, which create the ability to invest in residential real estate without having to actually buy or sell a house. The value of these two new derivatives is based on the Case-Shiller Home Price Indices, developed by Karl Case and Robert Shiller in the 1980s. There are 20 regional indices and a composite index that is calculated using the regional indices. The regional indices follow the value of home prices in 20 large U.S. metropolitan areas (Atlanta, Boston, Charlotte, Chicago, Cleveland, Dallas, Denver, Detroit, Las Vegas, Los Angeles, Miami, Minneapolis, New York, Phoenix, Portland, San Diego, San Francisco, Seattle, Tampa, and Washington, D.C.) by tracking the resale values of homes in each market. At this time, derivatives contracts are available for only 10 of the metro areas, but they will eventually be available for all areas. Other companies (Moody's, for example) calculate home price indices for other regions using the Case-Shiller methodology as well.

In this Economic Commentary, I explain how these indices are constructed and why they are better at tracking housing prices than some alternative measures cited in the financial media. I also explain how derivatives based on the indices--and some potential products which financial firms might use the derivatives to create, including home equity insurance, can protect homeowners against the volatility of residential real estate prices.

* Case-Shiller Home Price Indices: The Basics

At the simplest level, the Case-Shiller Indices are based on changes in individual single-family home prices as observed through the repeat sale of the same structures over time.

Box 1 contains a simple example of how the index can be calculated for Anytown, USA. Between 2001 and 2003, three single-family homes have been sold in Anytown. House A was purchased in 2001 for $300,000, but its owner put it on the market again the following year and sold it for $310,000, a 3 percent gain. …

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