Robert Shiller has long advocated the use of derivative real estate instruments to manage home equity risk and address the economic inefficiencies in the housing market. His body of work in this area is literally a Nobel, if not noble, idea, having led to his being awarded economics’ most prestigious award in 2013.
While Shiller carefully lays out the benefits of managing homeowner’s equity risk, to date, practical issues of hedging have been largely unexplored. With the 2006 listing of real estate futures contracts on the Chicago Mercantile Exchange (CME), it is now possible to examine hedging effectiveness using the CME derivatives. In the following analysis, we examine transaction data from Las Vegas and consider a simple futures rollover strategy alongwith hedging strategies whose payouts are related to changes in the underlying house price index.
The results indicate that idiosyncratic risk is large and renders hedging strategies ineffective for many homeowners that lost money on the sale of their house during the financial crisis.
The set of results include certain holding periods where hedge payouts are only a small fraction of their home equity losses and still other times when an individual would lose both on their home sale and on their derivatives position. Thus, the evidence suggests that while the idea of home equity risk management is a Nobel idea, hedging strategies can often lead to ineffective results.
Professor Steven Swidler ’75 is KPMG Professor of Business & Finance at Lafayette College. His main area of research is finance, and within finance, investments, derivatives, options and futures, along with some residential real estate research.
Sponsored by the Department of Economics Department and the Office of Alumni Relations (ASOC program).