Saturday, 7 October 2006

Real Estate - hedge against the bursting bubble

The Financial reported that the Chigago's Mercantile Exchange has launched futures and options that can mitigate the risk of house price movement:

"The CME will offer futures and options based on house prices in New York, as well as Washington, Boston, Miami, Chicago, Denver, Los Angeles and San Francisco. Las Vegas and San Diego, two of the hottest real estate markets over the past two years and the source of feverish discounting by some new-home builders, are also included, and could create volatility."

If you have a large fraction of your investment portfolio tied up in real estate (eg. your home), this could be a way to protect against declines in the value of your home now that the US property "bubble" appears to have started to deflate.

"Retail investors can use the futures in three main ways. The simplest, direct investment, lets you take a view on a housing market by going long if you think it will go up, or short if you think it is going down. This is not possible for all futures contracts. These will be settled in cash, unlike, for example, the CME’s frozen pork belly contracts.

A similar shorting strategy would allow homeowners planning to move within a limited time frame to lock in the current value of their property, with the contract paying out the difference, or at least part of the difference, if house prices decline before their planned move.

Each contract is valued at $250 multiplied by the index value. Thus to cover the value of a $500,000 home in Chicago, where in January 2006 the index stood at 163.98 – would require 12 contracts.

Finally, owners could link the value of their home to an index. For example, the home above could be listed at a constant 3,000 times the value of the Chicago index, tying its worth to the index and providing transparency to future buyers."

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