I am excited about this one!!! The only thing I can say is what took so long?
A simple explanation of why derivatives exist is that they allow people (or firms) to transfer risk. That is, derivatives allow those who want to to assume more risk to speculate and those who want to reduce their risk to hedge.
Given that for most people the most valuable single asset that they own is in real estate. It is troubling that real estate is also one of the most difficult assets to hedge. You can not short sell, generally (and there are some exceptions--REITs etc.) you have very limited ability to diversify, and until now no traded derivatives to transfer the risk.
That may be changing. From the NY Times Dec. 12,2004:
"Macro Securities Research, a company affiliated with Robert J. Shiller, the Yale economist, has reached an agreement with the Chicago Mercantile Exchange to list pairs of derivative instruments that are essentially index funds linked to home prices in certain markets. One instrument in each pair will rise as its market index rises; the other will rise as the same index falls. That will let investors bet on the direction of housing prices. Similar, but less sensitive, vehicles are being offered by HedgeStreet, a firm in San Mateo, Calif., that offers small-scale derivatives speculation online. "Quoting from the NY Times, the Montpelier Times Argus (quite the name for a newspaper!) has the following:
"Another set of derivative products linked to home prices was introduced in October by HedgeStreet, which specializes in online trading of pint-sized contracts it calls "hedgelets." Each is a yes-or-no wager that a housing index will be in a certain range on a given date within three months. After that period, the contracts expire, and losing bets are worthless. There are three residential property bets, representing percentage moves in an index whose level may be higher, lower or even with the recent trend in home price movements, for each of six cities: New York, Miami, Chicago, Los Angeles, San Francisco and San Diego.But the value of each contract is a paltry $10, and they are infrequently traded, at best, so unless you live in a matchbox, it would be difficult and very expensive to buy enough of them to provide a practical hedge."
Robert Shiller adds in the Daily Times of Pakistan
"Well-developed markets for real estate derivatives would allow homeowners to kick the gambling habit. A liquid, cash-settled futures market that is based on an index of home prices in a city would enable a homeowner living there to sell in a futures market to protect himself. If home prices fall sharply in that city, the drop in the value of the home would be offset by an increase in the value of the futures contract.
That is how advanced risk management works, as financial professionals know. But the tools needed to hedge such risks should be made available to everyone.
Attempts to set up derivatives markets for real estate have-so far-all met with only limited success. In May 2003, Goldman, Sachs & Co. began offering cash-settled covered warrants on house prices in the United Kingdom, based on the Halifax House Price Index and traded on the London Stock Exchange."
Shiller goes on to add that the real benefit for the home owner will be when these derivatives securities are made more user-friendly:
"Because even many financially sophisticated homeowners will find direct participation in derivative markets too daunting, the next stage in the development of real estate risk management will be to create suitable retail products. For example, the derivative markets should create an environment that encourages insurers to develop home equity insurance, which insures homeowners not just against a bust but also against drops in the market value of the home." Such insurance should be attractive to homeowners if it is offered as an add-on to their existing insurance policies."
Isn't that exiciting? and what great use of finance :) I am so proud :)
BTW I have to admit I had missed the NY Times article, I happened upon it when reading Michael Stastny's blog. Check it out!