The Revival of Housing Derivatives

An article in the latest issue of the Economist discusses the revival of housing derivatives, and its close connection with the recent financial meltdown. The idea first surfaced in 2006, when housing derivatives were available as futures contracts on the Chicago Mercantile Exchange. However, the housing bubble, and the fact that these were available only for sophisticated investors, reduced their popularity (detailed news reports available here and here). In June this year, two leading American economists in the area of American house-price movements have opened up the market to retail investors with the launch of a product called MacroShares. With the blow that the recent financial crisis has dealt to the belief that housing prices always increase, the time seems ripe for this idea to generate significant interest.

The Economist reports-

Derivatives have a bad name at the moment, but this sort is tame enough. MacroShares are securities that reflect the value of the S&P/Case-Shiller home-price index in ten large urban centres. The securities are issued in pairs, one for investors who wish to bet on the upward movement of house prices, and one for those who think prices will fall. That means every bet has an offsetting investment. Investors must also pay for their interest upfront, eliminating counterparty risks. And unlike actual homes, MacroShares are traded on public exchanges and are therefore liquid.

The next step is to tie derivatives more tightly to the interests of individual homeowners. MacroShares is already mulling a product tied to specific locations, rather than national house-price movements. A homebuyer in Miami, say, could offset the risk of price decline in the local area with a housing derivative. Lenders could end up wrapping these derivatives into mortgage contracts as a form of home-equity insurance.

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