NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Derivatives Markets for Home Prices


The principal problem [with] the market for real estate derivatives…[is] liquidity… institutional investors… observed relatively large bid-ask spreads and only small positions offered.

The near absence of derivatives markets for real estate, particularly single-family homes, is a striking anomaly that cries out for explanation, according to NBER Research Associate Robert Shiller. In the United States alone, the value of real estate held by households is about $20 trillion, which rivals the stock market. And yet the kinds of derivative instruments available for real estate are miniscule compared to those for stocks. In Derivatives Markets for Home Prices (NBER Working Paper No. 13962), Shiller talks about why we need such a market, how it might be designed, and why past efforts in the United Kingdom and, to a lesser extent, the United States have not been completely successful.

Two theories have been proposed to explain the lack of a derivatives market for housing: "the regret theory" and "the lack-of-hedging theory." The regret theory assumes that homeowners are reluctant to realize a loss on their house, so in a declining market, they delay selling. They may also avoid hedging their risks, for that too would force them to acknowledge the losses they already made. The lack-of-hedging theory, in its simplest form, means that people generally expect to live in a house forever, and if they don't plan to sell their property, then the price it might attain in the market is irrelevant to them. If that is the case, then hedging their home-price risks (as with derivative securities) might actually create problems, rather than solving them: if home prices should rise, then a homeowner who had shorted the market with derivatives would have to come up with the money to pay on the risk-management contract.

Neither of these theories is the primary reason for the slow growth of the derivative markets for real estate, Shiller believes. The regret theory does not seem powerful enough to be a long-term obstacle to hedging housing market risk. During a housing downturn, the decline in the volume of sales in the cash market for homes is typically no more than 40 percent. If one were to apply that ratio to the volume of trade in single-family home derivatives in the present market, it would suggest that there still should be a huge market for these securities.

The lack-of-hedging theory doesn't seem powerful enough either, Shiller feels, especially at present, when talk about the real estate market is everywhere, and when a "subprime crisis" fundamentally related to the real estate market has been described as the biggest risk facing the national economy. Instead, Shiller believes that there are inherent problems in getting any new market started, problems that are heightened when the new market is very unusual.

The principal problem, Shiller concludes, is that the market for real estate derivatives does not yet have enough liquidity. He reports that he spoke to institutional investors who considered placing orders in these derivatives but decided to wait a year, at least, because they observed relatively large bid-ask spreads and only small positions offered. Shiller suggests that "the liquidity of the futures and options market may be enhanced as other derivatives, such as index-linked notes, forwards, and swaps take hold."

-- Lester Picker


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