Lessons from the FOX Residential Property Futures and Mortgage Interest Rate Futures Market

Transcription

1 Housing Policy Lessons Debate from Volume Futures 5, Markets Issue Fannie Mae All Rights Reserved. Lessons from the FOX Residential Property Futures and Mortgage Interest Rate Futures Market Kanak Patel University of Cambridge Abstract On May 9, 1991, the London Futures and Options Exchange (FOX) introduced four property futures contracts to make possible the development of facilities for hedging, arbitrage, and price discovery in the commercial and residential markets. Two contracts were based on the Nationwide Anglia Building Society house price (NAHP) index and the FOX mortgage interest rate (MIR) index. Trading in the contracts was suspended in October 1991, partly because they failed to gain economically viable trading volume. To identify reasons for the failure, this article analyzes the opportunities and difficulties of using such contracts. The main findings are that (1) owing to lag dependence in the NAHP index, the futures contract did not provide the economic benefit from hedging market risk that stock index contracts provide and (2) potential arbitrageurs and speculators were deterred from using the MIR index contract because of high transaction costs and long time lags involved in processing new mortgage loans. Introduction Property futures and options markets can generate opportunities for portfolio management. For example, the introduction of financial futures has made possible the development of facilities for hedging, arbitrage, and price discovery while offering investors in the equity, bond, and currency markets asset allocation strategies. Yet such facilities are not available to investors in commercial or residential property markets. As Case, Shiller, and Weiss (1993) argue, What is needed is some market that stands between individual property owners and broader portfolio investors, allowing the portfolio investors to share the risk of the property market without owning it. What is needed, inherently, are futures and options markets cash settled on indexes of real estate prices. On May 9, 1991, the London Futures and Options Exchange (FOX) introduced four property futures contracts: a residential

2 344 Kanak Patel property contract, a mortgage interest rate (MIR) contract, a commercial property capital values contract, and a commercial property rents contract. These contracts were based, respectively, on the Nationwide Anglia Building Society house price (NAHP) index, the FOX MIR index, the Investment Property Databank commercial capital value index, and the Investment Property Databank commercial rent index. When the contracts failed to gain economically viable trading volume, trading in the contracts was suspended in October 1991 because false market prices were apparently being maintained. For potential users, it is important to understand the opportunities and difficulties of using such contracts. For futures exchanges, it is important to identify the main determinants of a futures contract s success or failure. The purpose of this article is to analyze the possible reasons for the failure of the NAHP index and MIR index contracts by comparing them with the successful Financial Times Stock Exchange (FTSE) index contract and the Short Sterling futures (SSF) contract. Apparently, several factors can account for a futures contract s success or failure: the appeal and relevance of futures markets to potential users, compatibility of the contract with the underlying cash market, liquidity and volatility in the cash and futures markets, and price discovery in a centrally organized market with an open outcry trading system. All these factors are closely related through the interaction of hedgers, arbitrageurs, and speculators in the marketplace. It is therefore necessary to study some of the motivations behind the NAHP index contract and the MIR index contract in terms of possible hedging, arbitrage, and speculative trading strategies. Before analyzing these motivations, it is appropriate to outline the contracts specifications and their underlying indices. Contract specification A futures contract is a commitment to buy or sell some designated instrument (commodity) at some predetermined future date at a price specified today. The price at which the parties agree to transact is called the futures price. At maturity, the commitment may be fulfilled by entering the futures market again and making a reversing trade or by making or taking delivery of the designated instrument as stipulated in the rules by the exchange. The vast majority of futures contracts are settled by reversing trades rather than by delivery. The

3 Lessons from Futures Markets 345 difference between the price at which the contract is sold and its purchase price is the trader s gain (or loss) on the futures position. Table 1 summarizes the specifications of the NAHP index futures contract and the MIR index contract. Table 1. FOX Residential Property Futures Contract Specifications Nationwide Anglia Building Society House Price (NAHP) Index FOX Mortgage Interest Rate (MIR) Index Trading unit 500 per index point 100,000 per lot Contract month March, June, September, March, June, September, December December Expiry day Fifth business day of Calendar day three months calendar month following following third Wednesday of contract month contract month a Last trading day Third Friday of calendar 11:00 a.m. on expiry day month Settlement The new NAHP index The MIR index released on the price released on first business calendar day three months day of month following following the third Wednesday contract month of contract month b Trading hours 9:30 a.m. 11:30 a.m. 9:30 a.m. 11:30 a.m. 2:30 p.m. 4:30 p.m. 2:30 p.m. 4:30 p.m. a For example, if the third Wednesday of March is the 21st, expiry will be June 21. b Based on the average effective rate (determined from a random sample of 16 of 25 designated mortgage lenders) for a defined home mortgage granted to borrowers from the third Thursday of the contract month until the expiry day. Disregarding the three highest and three lowest, the settlement price will be 100 minus the average of the remaining 10 rates. The futures price for the residential contract is quoted in the same manner as the NAHP index. The NAHP contract is worth 500 per index point. Thus, if the futures price is 224.0, the notional value of the futures is ( ) = 112,000. Contract expiration occurs in March, June, September, and December. The last trading day is fixed on the third Friday of the contract month. The NAHP index is published on the first business day of the month, and the contract settlement is set against the index published on the first business day of the calendar month following the contract month.

4 346 Kanak Patel Calculation of the NAHP and MIR indices The NAHP index is compiled on a monthly basis and released on the first business day of each month. The database covers all house price purchase transactions on which the Nationwide Anglia Building Society has approved mortgage loans. The characteristic mix of houses is standardized by isolating the variations in house prices that are caused by differences in qualitative characteristics (type of property, availability of certain amenities, location of the property, etc.) and by different quantitative characteristics (age of the property, size of the property, garages, number of bathrooms, etc.). For each house price P it, the regression coefficient b jt is computed for each of the j explanatory variables (physical and locational characteristics) for every quarter by using multivariate analysis as follows: P it = ƒ(x 1t, X 2t,..., X jt, e it ), (1) where e it is a group of unmeasured factors that are specific to each house. For each quarter, the sum of weighted regression coefficients (b jt W j ) is computed across 13 regions with weights corresponding to the proportion of qualitative variables and the arithmetic means of quantitative variables. The house price index I t for period t is calculated as the ratio between the exponent (exp) b jt W j and the same expression for the base period (first quarter 1983); that is, I t = exp b jt W j exp b j0 W j 100. (2) The MIR index is constructed to restrict the mortgage rate as closely as possible to the national average. To eliminate factors that would tend to move the rate away from the average, rates apply to mortgages with the following characteristics: 1. Variable rate 2. Sterling currency only 3. Size of loan national average 4. No deferred interest 5. Status three times salary 6. Advance to existing borrowers, 95 percent maximum 7. Endowment mortgages, 25-year term when mortgage issued 8. One month s notice of termination 9. No discount, no special offers

5 Lessons from Futures Markets 347 FOX selected a panel of 25 lenders representing more than 80 percent of the mortgage lending business done in the United Kingdom on the basis of the magnitude of their U.K. lending business as reported to the Council of Mortgage Lenders. FOX calculated a daily weighted rate for each of the 25 lenders from the daily mortgage interest rates provided by the lenders. A random sample of 16 of the 25 was selected, and the three highest and three lowest average rates were dropped. The remaining 10 lenders daily weighted rates were then averaged to produce the MIR index settlement price. Motivations behind residential property futures contracts The reasons for trading property futures are many and varied, including portfolio diversification, hedging of asset and/or portfolio risk, arbitrage trading, speculation, and price discovery. Although in practice it is almost impossible to isolate the array of motivations behind a particular trade, it is useful to illustrate some futures market trading strategies and assess the factors that may determine their success or failure. The following discussion focuses on some simple trading strategies that use the NAHP index contract and the MIR index contract. Portfolio diversification The risk-return characteristics of property investment suggest that property markets are influenced by forces that are separate and distinct from those influencing the financial markets. Many researchers considering the optimal asset allocation have suggested that the addition of property (residential housing, commercial property, and farmlands) to financial assets can provide significant diversification gains in portfolio performance. Webb (1990), using U.S. data, argued that two main reasons explain the inclusion of real estate in any market portfolio proxy. First, real estate of all types constitutes more than half of the total U.S. investable wealth; residential real estate alone accounts for almost 40 percent of the total U.S. investable wealth. Second, real estate offers substantial diversification benefits because of its low or negative correlation with equities and government bonds. Ziobrowski and Curcio (1992) reported that at all but the highest risk levels, U.S. real estate improved U.S. asset portfolio performance. The optimal U.S. portfolio, at the lowest risk level, comprised almost 50 percent real estate. Similar studies with

6 348 Kanak Patel British data (Howells and Rydin 1990; Lee 1989) have likewise concluded that the optimal allocation for property in a multiasset portfolio should be substantial. However, the actual investment by institutional investors (pension funds and insurance companies) in U.K. commercial property has remained below 20 percent and fell below 11 percent in the late 1980s. Meanwhile, institutional investors have not considered residential housing an active investment market. The absence of institutional investors from the housing market may be attributable to several characteristics that distinguish housing from other commodities and financial assets. The housing market is not a single market but a series of overlapping submarkets differentiated by location, quality, age, dwelling type, tenure form, and financing. As noted earlier, to improve the quality and reliability of house price information in the United Kingdom, the NAHP index incorporates some of these special characteristics. Further, NAHP index futures permit investors to diversify in residential property without acquiring physical property; they simply buy (or sell) the index futures. Investment of this type would represent, by definition, the riskreturn characteristics of the market insofar as the NAHP index reflects overall housing market performance. The concept of market-specific risk return is similar to that used in the stock market index futures, where investors can capture the behavior of the market by trading FTSE index futures. The specific risk associated with individual stock market securities (or sectors) can be avoided by using the FTSE futures contract. Similarly, the specific risk associated with investment in individual houses can be avoided by using NAHP index futures. As an example of the potential use of the NAHP index contract, consider an investor whose portfolio initially contains no investment in the U.K. housing market. Assume that the investor decides to take a position in the futures market by buying one NAHP index contract scheduled to expire in March. The investor is then said to hold a long position in the futures. Suppose that the NAHP index is at at the time the investor purchases the futures contract and has moved to by the expiry date. The investor then closes his or her long futures position by selling the contract at for a 1,250 profit. That is, the number of index points gained 500 per index point = = 1,250. If, instead, the investor s opening position had been to sell the futures contract at (a position said to be short in the futures), the investor would have incurred a loss of 1,250 by buying the contract at at the expiry date.

7 Lessons from Futures Markets 349 Effectively, the investor has created a synthetic property portfolio without holding physical property. Profit then accrues from favorable movements in the NAHP index. For institutional investors, an active mortgage interest rate futures market could provide an investment opportunity that does not exist in the primary mortgage market. Indeed, the U.K. primary mortgage market is dominated by building societies and commercial banks that have a well-developed network for taking deposits and issuing mortgage loans. This important financial sector all but lacks a secondary market. The MIR index futures contract, however, created a potential secondary mortgage market. The contract provided investors, pension funds, and insurance companies with readily available investment opportunities in the complementary interbank deposit market. Trading the MIR index contracts would enable investors to realize the riskreturn characteristics of the overall mortgage market. As an example, consider an institutional fund manager whose portfolio contains no residential mortgage-backed assets. Assume that the fund manager decides to buy March 10 delivery of MIR contracts when the index is at 85.0 (i.e., the average mortgage interest rate is 15 percent [100 85]). Suppose that on the settlement date the final settlement price is 86 (i.e., the average mortgage interest rate declined from 15 percent to 14 percent). The 100-basis-point gain in the futures position represents 2,500 profit (100 basis points 2.50 per index point = 2,500). As these examples demonstrate, the potential profitability of a correct futures position could be much greater than what could be earned with similar financial resources in the physical market. Because investing in futures requires only an initial margin equal to a fraction of the contract s face value (plus a daily variation margin), market participants can achieve a high degree of leverage. The leverage feature of futures contracts may attract more speculative trading and thereby help generate more liquidity in the market. Hedging property asset/portfolio risk Most hedging strategies attempt to eliminate price risk by trying to fix the price of a future transaction. If the change in the cash price during the hedge is exactly equal in magnitude and opposite in sign to the change in the futures price, a perfect hedge is obtained; if not, the hedge is risky. This type of risk is called basis risk. The difference between the cash price and the

8 350 Kanak Patel futures price is the basis. At a futures contract settlement date, the futures price and cash price must be equal and the basis must be zero. Up to the expiry date, futures contracts trade at a price higher or lower than the cash market price. The basis may widen or shrink with advantageous or harmful results to hedgers. The implications of basis risk for potential hedgers in the property market will become more obvious in the example given later. A hedge involves two types of basis risk: the cross-hedge basis risk and the time basis risk. Cross-hedge basis risk is introduced when, for example, the price of a property (or a portfolio of properties) is not perfectly correlated with the NAHP index. The time basis risk is introduced if the hedge termination date does not coincide with the NAHP index contract delivery date. Thus, if the NAHP index expires before the transaction date of the property that is being hedged, the resulting gain (or loss) on the property transaction will not equal the loss (or gain) in the futures position. Hence hedging can be considered an activity that exchanges price risk for basis risk. High basis risk translates into ineffective hedging and most likely deters potential hedgers from the futures market. The following simple example highlights some of the important conditions for controlling property market price risk. A company building residential properties typically faces the risk that the sale value of the properties will fall below the originally forecast price because of an unexpected downturn in the market. Exposure to such risk can be managed by hedging the full value or part of the value of the proceeds expected from the property portfolio s sale on the basis of the NAHP index futures. Suppose that on June 1, 1991, the company plans over the next six months to sell a portfolio of houses valued at 20 million. The company s objective is to offset any loss in the physical property (cash) market with a gain in the futures market if house prices decline. The company would have to use a short hedge, which involves selling an appropriate number of NAHP index contracts. The success of the NAHP index contracts in hedging the price risk of the company s property portfolio depends on the correlation between the movement of the portfolio value and the NAHP index. Assuming, for the sake of simplicity, that the price of the portfolio is perfectly correlated with the NAHP index, a perfect hedge can be obtained. That is, losses (gains) in the physical property market can be offset by gains (losses) in the futures market. Suppose that on June 1, 1991, the NAHP index was at 211.0; accordingly, the number of futures contracts required for a perfect hedge would be

9 Lessons from Futures Markets 351 Number of contracts = Value of property portfolio Current NAHP index 500 per point 20 million = (3) = = 190 contracts. Suppose that the property market declined throughout the next six months and the company sold its portfolio of houses for 19,449,000. Suppose also that on the expiry date of the contract in December the NAHP index had declined to and the company closed out its futures position by buying back 190 contracts. Thus, the company would have incurred a loss of 551,000 in the physical property market ( 20,000,000 19,449,000) and experienced a gain of 551,000 in the futures market (190 [ ] 500). This hedge worked out perfectly. Nevertheless, it is important to realize that this perfect hedge was obtained under ideal conditions. The success was due to the absence of cross-hedge basis risk and time basis risk. It is clear that the success of hedging the price risk of a particular portfolio of houses or individual houses is tied to how well the portfolio tracks the NAHP index. Since a house price index futures contract would most likely be used to hedge portfolios of houses that are not identical in composition to the underlying price index, the cross-hedge basis is an important consideration. The price of an individual house or a portfolio of houses may move in a direction opposite to that of the market index. On a regional basis, Giussani and Hadjimatheou (1991) have observed cyclical and secular differences in house price movements. Over their sample period, 1968 to 1988, the authors found a significant ripple effect between changes in house prices in Greater London and changes in other regions. The evidence suggests that year-to-year house price changes in Greater London lead house price changes in the rest of the country; the lag varied between two quarters and four quarters, depending on the distance between Greater London and the particular region. When house prices across different regions are aggregated into an index such as the NAHP, the index tends to display considerable inertia. Table 2 presents a sample autocorrelation function of the first differenced NAHP index. Approximately 68 percent of

10 352 Kanak Patel the variation in the NAHP index is explained by the previous quarter s variation and approximately 30 percent by the fourth quarter s variation. Table 2. Sample Autocorrelation Function of y t Nationwide Anglia Building Society House Price Index, January 1984 June 1992 Lags Autocorrelation coefficient Note: y t = y t y t 1 The implication is that the presence of lag dependence in the NAHP index reduces the housing market risk in relation to the specific risk associated with individual houses. Consequently, for the purpose of hedging market risk, the futures contract based on the NAHP index is not as advantageous as the FTSE index futures contract. A further difficulty in using NAHP contracts for hedging is the likely mismatch between the purchase or sale of houses and the futures contract expiry date. The preceding example assumed that the date on which the company sold its portfolio of houses coincided with the settlement date of the NAHP index contract. In a perfect hedge of this type, the price of the NAHP index contract equals the published NAHP index level on the settlement date; there is no time basis risk. In reality, the company would probably not know in advance the precise transaction date of its portfolio of houses and therefore would be unable to ascertain the appropriate futures contract at the beginning of the hedge period. The time delay inherent in trading in and out of physical property can work to either the advantage or the disadvantage of the hedger. Obviously, if the value of the physical property portfolio is lower than the value of the futures position after the termination of the hedge, the hedge is less effective. This uncertainty can be even more acute in a housing market recession, which is typified by sharp declines in housing market liquidity. Figure 1, demonstrating the extent of the liquidity problem in the market, shows the levels of the NAHP index and turnover over the sample period January 1985 to January The number of transactions in the market declined from approximately 600,000 in the third quarter of 1988 to below 400,000 from the third quarter of 1989 onward.

11 Lessons from Futures Markets 353 Figure 1. Nationwide Anglia Building Society House Price Index and Housing Market Turnover, January 1985 January (000) Index Transactions (thousands) NAHP Turnover When uncertainty surrounds the precise timing of transactions in the housing market, time basis risk can be minimized by using a combination of the near- and deferred-maturity futures contracts. Given, however, that the liquidity of deferred contracts tends to be lower than that of the nearest contracts, the investor is likely to make a tradeoff between time basis risk and cross-hedge basis risk. Such a tradeoff requires reliance on a combination of contracts with different maturities. Now let us examine the potential use of the MIR futures contract to hedge. The MIR index contract differs from other short-term interest rate contracts, such as the SSF contract, in that it is based on an index of mortgage interest rates constructed by the FOX. The SSF contract, by contrast, is based on the three-month interest deposits traded in the interbank market. To illustrate how the MIR index contract can be used for hedging, consider a building society that is granting a 200,000 mortgage loan at 15.0 percent on the third Wednesday of June Suppose that

12 354 Kanak Patel the mortgage loan is funded by a three-month money market deposit at a cost of 13.0 percent. The building society contemplates rolling over the three-month deposit at maturity in September The building society s treasurer is worried that the society s borrowing cost will remain at 13.0 percent but that the mortgage rate will decline to 14.5 percent in July and to 14.0 percent in August. To hedge against this risk, the treasurer buys 200,000 worth (that is, two contracts) of MIR index June 1991 contracts assumed to be currently trading at Suppose that the mortgage interest rate declines as expected to 14.5 percent in July and to 14.0 percent in August, that the MIR index contract is at 86.0 at the settlement date, and that the rate in the futures market declines by 100 basis points. The building society s position in the money and mortgage markets can be summarized as follows: Money Market Mortgage Futures Market (June September 1991) (June 1991) Money market interest Buy two June MIR index expense contracts at % for 3 months = 6,500 (September 1991) Mortgage interest received Sell two June MIR index 15.0% = 2,500 contracts at % = 2, % = 2,333 Total 7,250 Profit on loan Gain in the futures market 7,250 2 ( ) 100 basis 6,500 points 2.50 = The total profit including hedge equals 1,250, or 2.5 percent on 200,000 for three months. The building society s expected profit that is, the spread between interest received and funding cost would have been 1,000 if the mortgage interest rate had remained at 15.0 percent. The 250 loss in income caused by the decline in the mortgage interest rate was more than offset by the gain of 500 in the futures market.

13 Lessons from Futures Markets 355 This example may seem unrealistic in view of the assumptions that the hedge is terminated on the June contract settlement date and that there is no basis spread between the futures price and the mortgage rate on the starting date of the hedge. For this type of variable-rate mortgage, the mortgage rate is not fixed for any set time period. When the building society granted the 200,000 mortgage commencing on the third Wednesday of June 1991, it knew the rate but not the period of time for which it would apply. In this example, the society will not know until mid-september the amount of interest earned over the threemonth hedge period. Thus, in practice, this source of uncertainty greatly complicates hedgers decisions about when to put on, keep on, and take off hedges. Arbitrage trading and futures price relationships The activities of arbitrageurs have a pronounced effect on the efficiency of a futures market. In a well-functioning futures market, arbitrage operations ensure that prices in the futures market and the underlying cash instrument are closely linked. The basic principles involved in pricing the MIR index futures can be examined by comparing the index futures contract with the SSF contract. Like the SSF contract, the MIR index contract is a variable-rate contract. Theoretically, the SSF contract is priced as 100 minus the three-month implied forward rate on a notional 500,000 interbank offer deposit. Given the highly liquid interbank deposit market, the implied forward rates can be calculated from the relevant maturity deposits for any maturity dates covered by the SSF contracts. In general, SSF contracts trade within the narrow no-arbitrage bands that are established by comparing the futures rates with the relevant forward rates. The basis spread between SSF futures and forward rates observed by Patel and Paxson (1990) over the sample period December 1985 to June 1989 was 9.65 basis points in the third-nearest contract category, 5.58 basis points in the next nearest, and 2.08 basis points in the nearest. At a given point, an arbitrage band is a function of bid offer spreads and transaction costs in the interbank deposit market and the margin requirement in the futures market. Typically, 33 percent of the band seems to be due to the percent bid offer spreads, 65 percent to other transaction costs, and about 2 percent to the initial margin requirement. In general, mortgage interest rates follow the three-month London Interbank Offered Rates (LIBOR). Figure 2 displays the LIBOR and the MIR index and reflects the interest rate

14 356 Kanak Patel Figure 2. London Interbank Offered Rates (LIBOR) and the FOX Mortgage Interest Rate Index Percent per annum /86 6/87 12/87 6/88 12/88 6/89 12/89 6/90 12/90 LIBOR FOX Mortgage Rate environment over the period December 1986 to December Although mortgage rates follow the general trends in the LIBOR, the monthly changes in the MIR index lag behind the LIBOR, while mortgage rates tend to be relatively more stable. The correlation coefficient between the monthly changes in the LIBOR and those in the MIR index is Indeed, several other differences between the SSF contract and the MIR index contract are worth noting. First, unlike the SSF contract, the MIR contract is based on an index of average mortgage rates computed by the FOX. As in the case of other index-based contracts, mortgage lenders and borrowers could hedge the mortgage market interest rate risk, but the effectiveness of the hedge would depend on how closely the particular mortgage rate moved with the MIR index. Second, and perhaps more important, is the absence of the secondary trading of mortgage-backed securities. In the absence of a secondary market, it is not feasible to derive an arbitrage pricing relationship between the MIR index futures rates and implied forward rates for mortgages. Third, although the SSF contract is the closest approximation to the mortgage market, large deviations in the two rates have persisted at times. The cross-arbitrage pricing relationship could be derived theoretically, but in practice, the costs involved in taking short positions in mortgages can be substantial. Next, to gain some insights into the pricing relationship between the NAHP index futures and the level of the underlying index, it is useful to consider the well-established cost-of-carry model of

15 Lessons from Futures Markets 357 stock index futures pricing. In the case of stock index futures, a simple formula can determine the fair value of the futures contract for a given underlying index level. At a given point, the fair value is equal to the value of the (carrying) cost of owning stocks and dividends forgone and is expressed as Futures price = index price + interest on index price index dividends. (4) Buying the futures contract allows the investor to reinvest the price of the index, which would have been tied up had the investor purchased the portfolio of securities contained in the index. On the other hand, owning the index allows the investor to earn the dividends paid by component stocks. This framework stipulates permissible bounds for stock index futures prices. The difference between the current index level and the futures value cannot deviate from the cost of carry except by an amount too small to attract arbitrage trading. To engage in arbitrage trading, the trader must be simultaneously aware of the futures price, the price of each share in the index, the dividends anticipated on each share up to the contract expiration date, the cost of borrowing funds, and the transaction costs incurred in trading. These considerations highlight the market conditions that would be necessary for feasible arbitrage operations in the NAHP index futures market. Uncertainty about trading timing and high transaction costs are among the major obstacles to potential traders planning to take short positions in the physical property market. In addition, apart from property development companies holding diversified portfolios of houses, both long and short positions in the market approximating the NAHP index would entail considerable exposure to market timing and price risk. Another important limitation to arbitrage operations is that the information pertaining to characteristics of houses and transaction costs is not publicly available in the marketplace. In the absence of arbitrage operations, no mechanism in the market can ensure that the regular price relationship between NAHP index futures and cash prices will be maintained. Speculation and price discovery The previous section highlighted several problems in implementing the cost-of-carry arbitrage relationship in pricing the NAHP index and MIR index contracts. Speculative trading, however,

16 358 Kanak Patel results in another important linkage between the cash and futures markets. Futures prices, insofar as they represent the prices of goods to be delivered and paid for at a future date, embody investors expectations about future spot prices. Speculators in futures markets take long or short positions depending on whether their expectations about future spot prices are higher or lower than current spot prices. As in other markets, speculators or professional risk takers in NAHP index futures attempt to forecast the movement of prices in the property market and, by taking appropriate positions in the futures market, to make a profit if their judgment proves correct. Speculators presence in the marketplace would ensure that the price of an NAHP index contract at any given time would approximately equal the expected level of the index at its expiration date. If the divergence between the futures price and the expected spot index level is too great, profitable speculative opportunities will result. In this respect, speculative trading can provide the valuable service of price discovery in the property market. It is probably fair to say that price discovery appears to be the primary rationale behind NAHP index futures. Speculative trading in this contract could provide important benefits, such as continuous, accurate, well-publicized price information. As noted earlier, the physical property market is characterized by high transaction costs, long time lags in trading in and out of properties, and insufficient accurate information. As a consequence, traders are usually able to take advantage of long run cycles. A property futures market would, however, entail lower transaction costs and provide an efficient, regulated, and liquid medium for trading the market price risk. More important, because traders could take short positions, NAHP index contract prices could reveal valuable early market forecasts, especially when the physical market becomes less liquid during a recession. Current futures prices may of course differ from subsequent levels of the NAHP index observed at a future date. If the discrepancy is large, the forecasts contained in NAHP index futures prices may not be useful. Conclusion This article has highlighted the opportunities and difficulties associated with using the NAHP index and MIR index contracts for potential hedgers, arbitrageurs, and speculators. From the viewpoint of portfolio management, NAHP index futures offer institutional investors the opportunity to diversify their portfolios without the need to hold physical properties. An active

17 Lessons from Futures Markets 359 market in such a futures contract could also provide important benefits including continuous, accurate, and well-publicized price information. The characteristics of this index-based contract suggest that price discovery may have been the primary rationale in designing the contract. The failure of the NAHP index futures seems to be partly due to the inherent problems with construction of the index (lag dependence over time) and, given the illiquid nature of the cash market, substantial time basis risk. Although the NAHP index contract was designed to provide users of stock index contracts with portfolio diversification and risk management opportunities, two main differences distinguish the NAHP index contract from the widely traded FTSE index contract. First, given the restrictions on short-selling a portfolio of houses, the standard futures and cash market arbitrage relationship would not be useful in pricing the NAHP index contract. Therefore, at any given point, market participants would have no mechanism for ensuring what should be the fair value of an NAHP contract. The absence of such a mechanism may have been the main obstacle facing potential hedgers and arbitrageurs in the market. Second, owing to significant ripple effects triggered by changes in house prices across different regions, the NAHP index displays significant lag dependence over time. As a consequence, NAHP index contracts do not provide the same economic benefit from hedging market risk as that offered by the FTSE index futures contracts. Further, because of the high transaction costs and long time lags involved in buying and selling houses, potential hedgers are likely to encounter substantial time basis risk. The potential benefits of a mortgage-interest-rate futures contract are substantial. Such a contract could provide institutional investors with an investment opportunity that does not exist in the primary mortgage market. It could also provide borrowers and lenders with an efficient mechanism for managing interestrate risk. Finally, professional arbitrageurs and speculators could realize profitable opportunities from divergences that may arise between the mortgage-interest-rate contract and the SSF contract. A possible cause of the failure of the MIR index contract, in comparison with the SSF contract, seems to be the nature of the underlying cash market. Both high transaction costs and long time lags involved in processing new mortgage loans may have deterred potential arbitrageurs and speculators from using the MIR index contract. Lessons from the failure of the NAHP and MIR futures contracts for futures exchanges designing similar contracts are (1) to make

18 360 Kanak Patel sure that the underlying index adequately reflects the market risk and, (2) more important, to search for ways of reducing the time basis risk. Author Kanak Patel is a Lecturer in Property Finance at the Department of Land Economy, University of Cambridge. The author wishes to acknowledge the helpful comments of Dean Paxson and Christine M. E. Whitehead and those of Peter Dickinson on an earlier version of this paper. As usual, the author remains responsible for residual errors. References Case, Karl E., Jr., Robert J. Shiller, and Allan N. Weiss Index-Based Futures and Options Markets in Real Estate. Journal of Portfolio Management (Winter): Giussani, Bruno, and George Hadjimatheou Modeling Regional House Prices in the United Kingdom. Papers in Regional Science 70: Howells, Peter G. A., and Yvonne J. Rydin The Case for Property in Investment and Implications of a Unitized Property Market. Land Development Studies Education Trust 7: Lee, Stephen L Property Returns in a Portfolio Context. Journal of Property Valuation and Investment 7: Patel, Kanak, and Dean A. Paxson Basis Convergence and Rate Volatility in Sterling LIBOR Futures. Review of Futures Markets 8: Webb, James R On the Exclusion of Real Estate from the Market Portfolio. Journal of Portfolio Management (Fall): Ziobrowski, Alan J., and Richard J. Curcio The Investment Characteristics of Real Estate in Other Countries. Appraisal Journal (April): Bibliography Baum, Andrew Property Futures. Journal of Property Valuation and Investment 9: Gammill, Gordon Futures Trading and Finance in the Housing Market. Journal of Property Finance 1(Autumn):