The Blackwell Companion to the Economics of Housing: The Housing Wealth
of Nations edited by Susan J. Smith and Beverley A. Searle, chapter 21, forthcoming, 2010.
Trading on house price risk
Index derivatives and home equity insurance
Peter Englund
Stockholm School of Economics
and
University of Amsterdam
Recent developments of public sector welfare systems and financial markets offer new
incentives as well as new opportunities for households to make active financial decisions.
New financial instruments and better functioning markets facilitate hedging health and
income risks. The well informed and rational individual can now actively trade off risk
against expected returns. Still some of the major risks in life remain difficult to affect, those
associated with housing choices being perhaps the most conspicuous example. For most
households buying their home is the major investment in life and the home is the major asset
in the wealth portfolio of most households. But this is an investment driven by consumption
motives rather than by risk-and-return considerations. Households choose to own because the
ownership market offers them more flexibility of choice and because owning solves some
basic agency problems that are not well handled by a rental contract. Households choose the
amount of housing investment out of consumption needs rather than by thinking about
optimal portfolio composition. As a result many households end up with very unbalanced
portfolios with several hundred percent of their net wealth invested in real estate. While this
might be optimal from a risk-and-return perspective for some households, it is certainly not
universally so.
Modern financial technology should be useful also for trading in housing risk. In this chapter I
will discuss how financial derivatives could be used to enable households to disentangle
consumption from investment decisions and to adjust their exposure to housing risk without
any consequences for their consumption of housing services. The next section gives a short
introduction to the importance of housing in household wealth portfolios. This is followed in
section 2 by a characterization of the risk and return properties of housing as an investment
object. The following two sections provide a brief analysis, drawing on the recent academic
1
literature, of the potential gains if households could trade in financial instruments related to
house price indexes. Finally, section 5 reviews current market experiences and proposals to
create new home insurance products and index derivatives markets. Section 6 concludes with
a brief discussion of likely future developments.
1. The owned home in household portfolios
In economic analysis, we typically distinguish between investment and consumption
decisions. For housing, however, these two decisions are intertwined. In principle, they can be
disentangled by making the consumption choice through renting housing services and the
investment choice by purchasing some form of real estate securities. In practice, most
households aspire to own their home for reasons not primarily related to investment returns.
In industrialized countries 6 out of 10 households are homeowners. This average conceals
large differences across countries, from lows of 30-40 percent in Switzerland and Germany to
highs of round 80 percent in Spain and Ireland. In many countries – such as the United States
– a high rate of homeownership is an explicit political goal and tax policies and mortgage
market institutions are directed at easing access to homeownership. In other countries – like
Sweden – stated policy objectives indicate neutrality towards the choice between owning and
renting.
In practice, transaction costs and the availability and cost of mortgage finance are probably
the most important factors explaining the differences in homeownership across countries.1 In
many countries the tax deductibility of mortgage interest payments is not fully offset by
property taxes or other taxes on the returns to homeownership, whereas the taxation of the
rental sector tends to be approximately neutral. In most countries the fraction of homeowners
has been increasing in recent decades, largely as a result of improved borrowing opportunities
following deregulation and technological innovations in the financial industry. This
development has probably been welfare-enhancing by allowing access to homeownership for
many low-income households previously locked out from this market by high downpayment
requirements. But, as witnessed by the current sub-prime mortgage crisis, it has exposed
many of these households to new risks that they are ill-prepared for.
2. How risky is housing?
1
See, e.g., Hilber (2007) for a study of the determinants of ownership rates across Europe.
2
Homeowners are well aware that house prices fluctuate. Under normal conditions this may
not be a major concern for current owners, as long as it does not directly affect their housing
expenditures. In fact, rising prices may even be seen as bad news insofar as they affect the
base for property taxes. House price fluctuations do, however, become of more direct concern
for anybody who considers moving from one area to the other, as price movements are often
not well coordinated across regions. In fact, it seems that variations in overall housing price
levels coincide with variations in relative prices. As one illustration, figure 1 depicts an index
of the relative price between a Scotland and a London one-family house. During the two
periods (1983-88 and 1996-2002) when house prices in general sky-rocketed in all of the
United Kingdom, the London price level doubled relative to that of Scotland. In the years in
between, on the other hand, both absolute and relative prices moved in the opposite direction.
In 1993 the price of a London home relative to a Scotland home was back at the 1983 level.
Clearly, such fluctuations represent substantial risks with an enormous impact on the
distribution of life-time resources across households with different patterns of mobility.
In order to analyze the riskiness of homeownership in more detail, we need to first discuss
how to measure the returns to owning a home. The returns consist of two main components:
the capital gains (and losses) and the value of the housing services enjoyed by living in the
house (the implicit rent that the homeowner “pays to himself”). The capital gains cannot be
observed with any precision until the house is sold and the gains (or losses) are realized. Yet,
they make up an important and risky part of returns and to assess the full risks of housing we
need to measure the gains per period as they accrue during the holding period. Returns can be
measured using (the log difference of) price indexes constructed based on observed
transaction prices. In such indexes, the heterogeneous nature of houses is accounted for either
by hedonic regressions or by repeat-sales estimates (or with some combination of the two). It
is important to emphasize that house price indexes are statistical constructs valid for a
representative house. They are not exact measures directly applicable to an individual house,
nor do they measure the price and returns of a well defined continuously traded portfolio of
properties analogous to, e.g., stock price indexes. Rather, they should be interpreted as
measures of the development of expected sales prices for a representative house.
There are at least three important differences between a house price index and a stock index
that are important to keep in mind when comparing return properties and discussing the
viability of various index related derivatives. First, it is not possible to trade directly in the
3
portfolio of properties underlying the house price index. While this problem may not matter
for index construction, it is a strong deterring factor in developing a market in index
derivatives. Second, house price indexes are always measured with error. Third, the returns as
indicated by price index changes do not account for the idiosyncratic risk associated with an
individual house due to unique characteristics of the house as well as the special nature of the
transaction when a house is traded.
The other component of returns, the implicit rent, is also fraught with measurement problems.
The natural approach would seem to be to use market rents, in which case the measurement
problems would “only” be those related to the heterogeneity of dwellings, i.e. in principle the
same problems as with price indexes. Unfortunately, rent indexes have the added problem that
rental markets are often regulated or otherwise poorly functioning. In fact, they may be close
to non-existent for one-family houses in many countries. Furthermore, even in unregulated
rental markets observed rent variations are restricted by long-term contracts, and fluctuations
in vacancies is an important equilibrating mechanism. In practical calculations of housing
returns, implicit rents are often measured by simple rules of thumb, such as a fixed percentage
of market prices. As a result, the variability of housing returns is likely to be understated. This
may not be too serious, however, since the “cap rate” that translates prices into implicit rents
is likely to have a low variance relative to the capital-gains component of housing returns. In
terms of providing inputs to a portfolio choice problem, it is probably more problematic that
the level of rents, and hence expected returns, is based on such ad hoc assumptions.
Bearing these caveats in mind, a number of authors – e.g. Goetzmann (1993), Flavin and
Yamashita (2002) for the U.S., Englund, Hwang and Quigley (2002) for Stockholm,
Iacoviello and Ortalo-Magné (2003) for London, and le Blanc and Lagarenne (2004) for Paris
have computed the means and variances of housing returns. Generally speaking, they all find
that housing is an average asset with mean returns and variance higher than for bonds but
lower than for stocks. Estimates of mean return vary quite a bit across studies, however, partly
reflecting the particular sample period. As an example, the London data used by Iacoviello
and Ortalo-Magné refer to an extended boom period. Furthermore, housing returns appear to
have a generally low correlation with other assets, making housing attractive in a welldiversified portfolio. Measures of correlation should be interpreted with caution, however, as
they are likely to be biased toward zero because of measurement errors in the underlying price
index.
4
3. The gains from being able to invest in a housing index – a first look
The return characteristics reported by the authors referred to in the previous section indicate
that housing is not an unattractive asset from a portfolio perspective. Applying standard
mean-variance analysis to the data presented in the studies mentioned in the previous section
yield optimal housing portfolio shares in the minimum-variance portfolio on the order of 3070% of the net wealth (assets minus debt). This can be compared with observed portfolio
shares. According to Flavin and Yamashita (1998, tab. 2) the average US home-owner has a
portfolio share around 150% with many young households at much higher levels. Compared
to the benchmark provided by the mean-variance model, the average renter is under-invested
and the average home owner is over-invested in housing. Both household categories would
stand to gain from access to a market that allowed them to freely adjust their housing portfolio
share.
How costly is the absence of markets that would allow them to adjust their exposure to house
price risk? What are the costs of today’s market incompleteness in terms of excessive risk
taking or returns foregone? Let us make the following thought experiment. Consider a
representative highly leveraged home-owner with, say, 400% of her net wealth invested in a
house (typical for less wealthy home-owners in countries with well-developed mortgage
markets) and a representative renter with zero housing investment. Now, assume that we
introduce the possibility to trade in the housing index and ask how this opportunity would
impact on the combinations of expected return and variance that are available to our
hypothetical household.
Answers to this thought experiment in the form of attainable combinations of risk and return –
efficient frontiers to use the language of portfolio theory – are depicted in Figures 2 and 3,
constructed based on Swedish data as reported in Englund, Hwang and Quigley (2002).
Before discussing the graphs, there are two things to note. First, this example accounts for the
availability of other marketable assets, apart from the house price index, that are correlated
with house prices. In particular, the menu of assets includes shares in property companies
quoted on the Stockholm stock exchange. In the U.S. and other economies, real estate
investment trusts (REITs) would be a natural investment alternative. Second, the calculations
account for the fact that the returns to an individual house include an idiosyncratic component
5
that is not captured by the price index. The variance of this component – as estimated by
Englund, Quigley and Redfearn (1998) – is quite large. According to those estimates the
quarter-by-quarter variance of the returns to an individual house is about five times as large as
that of the price index. The relative importance of the idiosyncratic component diminishes
over time, however, and at a 5 or 10 year horizon the variance in return to an individual house
is only about twice that of the index.2
Figure 2 depicts two different efficient frontiers for a hypothetical home owner with 400 % of
her net wealth invested in her home. It holds the housing investment fixed and allows the
investment in other assets to vary so as to attain the best possible combinations of risk and
return. The curve to the right illustrates the situation when our home owner is restricted to a
standard set of investments apart from the own home – treasury bills, bonds, common stocks
and property company stocks. It shows how she may trade off reductions in risk against
reductions in expected returns. Because of the leverage effect due to the combination of a
large housing investment with indebtedness, our homeowner cannot avoid facing quite a bit of
risk. In fact, it is not possible to bring down the standard deviation below 37 %, at which level
the expected return is only 2.3 %. With some more appetite for risk it is possible to increase
the expected return, e.g. to 8% at 57% standard deviation. The curve to the left illustrates
corresponding combinations of risk and return when it is also possible to trade in a house
price index.3 The homeowner now wants to take a short position in the index in order to
hedge against the risk of falling house prices. A very risk averse homeowner can now reduce
the standard deviation down to 24%. At a 37% standard deviation – the minimum possible
with index trading – he can now get an 8% expected return, compared to 2.3% in the absence
of index trading.
Having access to index related products is also attractive for renters. Analogous efficient
frontiers for a hypothetical renter with zero house investment are depicted in figure 3. At very
low risk levels the difference between the two frontiers is very small. The reason is that it is
possible to achieve virtually zero risk by only investing in treasury bills. At higher risk levels,
however, also renters stand to gain by investing in an index. At 20% standard deviation the
expected return increases from 6.3% without index trading to 7.1% if the renter is allowed to
2
Other studies, such as Goetzmann (1993), find more persistence in the idiosyncratic component.
For simplicity the calculations assume direct trade in the index itself rather than in an index-linked future or
option. Presuming that liquid such markets exist, futures and option prices should be highly correlated with the
underlying index.
3
6
invest in a house price index. All these calculations cannot be taken as more than illustrative,
but they do suggest that opening a market for trade in housing price indexes should have
positive welfare consequences, for renters as well as owners.
4. A Richer Framework
The static mean-variance model allows us to have a first shot at understanding the risk
exposure of homeowners, but it is strongly oversimplified in crucial respects. An obvious
limitation is that the return is only evaluated in terms of end-of-period wealth. But in a
dynamic setting owning one’s home offers insurance against future housing consumption
risks as emphasized by Sinai and Souleles (2005). For a household planning to stay in its
current housing market the entire life, the development of house prices may not be much of a
concern. An owner could afford to stay in the same house no matter what the development of
house prices. A renter, on the other side, would have to cut down on the consumption of other
goods as a consequence of future rent increases.
In general one needs to distinguish two types of risk: an investment risk and a consumption
risk. The investment risk can be hedged by a short position in the current housing market (by
selling a price index), whereas the consumption risk would be hedged by taking a long
position (holding property) in those markets where the household expects to live in the future.
For a household that assigns zero probability to ever changing housing market these two
hedging demands exactly cancel each other. On the other hand, a household that is certain of
moving next year would obtain an investment hedge by shorting its current market and a
consumption hedge by going long in the market of destination. In general, rational households
should assign probabilities to a variety of housing careers and adjust their exposures
according to these probabilities. A recent working paper by Voicu (2007) provides a detailed
analysis of optimal portfolio choice with investment and consumption risk in the presence of
housing index derivatives.
Another shortcoming of the standard application of the static model is that it disregards other
sources of uncertainty than the returns to the various financial assets included in the portfolio
choice problem. It treats the house as a predetermined “background” investment, but it does
not account for other sources of background risk. The most important such risk is related to
7
future labour income streams, i.e. to the returns to human capital. Omitting income risk from
the analysis may lead to misleading conclusions, since human capital and housing tend to be
positively correlated. This correlation is likely to be particularly strong in “company towns”,
where the labour and housing markets are dominated by a particular industry or even a single
employer. The standard calculation underlying figs 2 and 3 portrays housing as a rather
attractive asset, since it is essentially uncorrelated with stocks and bonds. But an individual
working for the main employer in a company town is already exposed to local labour market
risk. By owning his home he would get doubly exposed. Hence, this would cause his hedging
needs to be even stronger than the standard analysis suggests.
Interestingly, it seems that households tend to take the correlation between housing and
human capital into account in choosing mode of tenure. Research by Davidoff (2006) and
Jansson (2008) indicates that the stronger this correlation the less likely households are to
own their homes. Jansson employs data on a large panel of Swedish households to estimate
the risk of becoming unemployed (the most important human capital risk). Using the
estimated equation, he computes a time series of unemployment risks for each household
based on the household head’s age, education, place of residence etc. and uses this series to
calculate, for each household, the correlation with a local house price index. It turns out that
for the great majority of households this correlation is negative (implying a positive
correlation between the returns to human capital and housing). The median correlation is as
high as -0.6. Jansson then estimates a probit equation of household choice of owning versus
renting and finds that the correlation between house prices and unemployment has a
significantly negative impact on the probability of being a homeowner. The quantitative effect
is rather small, however, and many households remain overexposed to local labour market
risks.
Accounting for mobility and income risk is certainly very important in understanding the
potential severity of house price risk at the level of an individual household. The simple oneperiod portfolio model is indeed seriously incomplete. The implications of the suggested
modifications for portfolio choice go in different directions, however. Taking a longer time
perspective, accounting for the possibility that the household may not be moving, suggests
that owning your home may be less risky than indicated by the static model, whereas adding
income risk to the model suggests it is more risky. The general conclusion therefore remains
8
unaltered: allowing households to trade in index instruments has a strong potential to improve
risk-return trade-offs.
5. Completing the markets in practice
There is apparently a lack of well functioning markets that allow households and investors to
adjust their positions in the housing market. Despite the rapid developments in recent years,
financial markets remain incomplete in this important sense. From the discussion above we
conclude that introducing such markets may not be of major importance for all, but should
offer welfare improving opportunities for many households. Specifically (i) current
homeowners with a high probability of moving in the near future would like to short their
current housing market of residence and go long their market of destination; (ii) current
renters who are contemplating owning in the future would like to be long their market of
destination; (iii) investors in general – current renters in particular – would like to add some
housing market exposure to their investment portfolio.
Over the last couple of decades economists have made a number of different proposals to
create new markets and institutions that would allow households to alter their housing market
exposure. Some of these are institutional arrangements or insurance products directed
primarily at satisfying the hedging needs of current homeowners, category (i) above, whereas
others are traded financial instruments that should be equally useful for anybody wanting to
take a positive or negative position in the housing market. It is convenient to discuss these
proposals under three separate headings: (a) new institutional arrangements for home
ownership; (b) traded derivative instruments; (c) non-traded insurance and mortgage products.
5a New forms of homeownership
From one perspective the basic problem is the indivisibility of housing units. Today,
households face the all or nothing choice between owning an entire dwelling and not owning
any housing at all, whereas optimal risk sharing would suggest owning just a fraction and
having outside investors own the remainder. Making this possible is the basic idea behind the
proposal of housing partnerships as launched by Caplin et al. (1997), and indeed behind the
wide array of traditional shared equity arrangements discussed by Whitehead and Yates in this
volume The resident household would naturally be the managing partner and have the full
right to take day-to-day decisions and also decide on when to sell. Other details – e.g.
9
regarding decisions about major investments and sales procedures – would have to be
specified in a contract between the parties.
In principle, the partnership idea is a perfect solution to the homeowner’s problem, as it
allows offloading any fraction of the risks associated with a particular dwelling, not just those
related to house prices in general. The problem is to ascertain that incentives for maintenance
and sales effort are well aligned between the partners. To mitigate moral hazard problems –
e.g. that the managing partner neglects maintenance – there is need for a relatively detailed
contract between the partners. Even so, any contract would necessarily be incomplete and
there would remain elements of the agency problems that make renting a cost-ineffective
mode of consuming housing services (Henderson and Ioannides, 1983). Nevertheless, this is
quite an interesting proposal as it addresses the central problem of homeownership head on.
But since it may require new legislation, and in any case is likely to take long to get consumer
acceptance, it is not of major importance in the foreseeable future.
5b Traded index derivatives
The idea of setting up markets for index derivatives, see e.g. Case, Shiller and Weiss (1993)
and Shiller (1998), is a very natural one. The exact form of the derivative – whether it be
futures, options, swaps or some other contract – may not be so important. The general idea is
simply to introduce an asset that would allow households and investors to change their
exposure to housing market risk without altering the amount of direct ownership. It may be
most straightforward to think in terms of a futures contract. A future is an agreement made
today to exchange a certain item – e.g. a number of shares or a quantity of pork bellies – at a
certain future date at a price that is fixed today. In practice, there is rarely any exchange of
shares or pork bellies at the settlement date. Instead the deal is settled in cash, i.e. by a
transfer of the difference between the agreed-upon futures price and the settlement price (the
market price of the underlying asset at the settlement date). Most futures contracts are related
to underlying traded assets, where direct physical settlement would be possible, but there is
nothing in principle preventing trade in futures contracts where physical delivery is not
possible, such as a property price index.
The first example, to my knowledge, of an exchange traded market for property price index
futures was the London Fox market in the early 1990s. These futures were based on the
Nationwide HPI. Unfortunately, the market was closed already after a few months of low
10
trading activity. Patel (1994) ascribes this failure to the announcement of fictitious trading
prices in an attempt to give an inflated impression of market activity, though as Smith (2009)
points out the failure was somewhat more complex than this implies. More recently, in 2005,
the Chicago Mercantile Exchange (CME) started trade in futures and options based on CaseShiller house price indexes for ten metropolitan areas in the U.S as well as a composite of
them all. Recently, indexes for another ten metropolitan regions have been added. So far,
trade has been limited in quantity, but active enough to generate daily price quotations.
Labuszewski (2006) and the financial panel discussion in this volume give more details on the
development of this market.
While the CME futures and options may be the only example of exchange traded housing
index derivatives, there has recently been an increasing activity in over-the-counter (OTC )
trading related to commercial price indexes, primarily in swaps. The most active market is in
swaps between LIBOR and total returns on the UK IPD index. The notional value of all
contracts currently outstanding is around GBP 8 bn. While this is only one or two percent of
the total value of all commercial property in the UK, it is still enough to maintain a liquid
market. There is also a somewhat less active swap market in the UK Halifax residential index.
The relative success of these markets has generated a considerable interest from the financial
industry, and it appears that new markets are now starting to develop in many countries.4
5c Insurance products
The development of new index derivatives markets discussed in the previous section is very
exciting. It is not likely, however, that traded derivatives will attract much attention from the
average homeowner (though see Smith, this volume). Derivatives contracts may seem
difficult to understand, and many individuals may perceive them as risky, even if they
actually serve to mitigate risk. Further, the contracts that are traded today (e.g. at CME) are
for large metropolitan areas with limited relevance for the individual homeowner. Neither the
inhabitants of Bronx nor of Nassau County may find the New York metropolitan area index
suitable for hedging. Insurance type contracts should be more familiar and easier to
understand for most homeowners. Furthermore, such contracts could be linked to more local
price indexes or perhaps even to the transaction price of an individual property.
4
See, e.g., Risk and Manage. The Newsletter of the Property Derivative Market
(www.tfsbrokers.com/pdf/RISK&MANAGE/2007/Oct-07.pdf).
11
The individual homeowner would ideally like to sign an insurance contract against
fluctuations in the value of his own house. For obvious reasons, as discussed above, such
contracts would meet with serious problems of moral hazard and adverse selection. They have
only been offered under very special conditions. To name one example, a Swedish broker,
Ragnar Bjurfors AB, was for some time in the early 2000s offering a guarantee to cover any
loss in connection with the sale of a house. The guarantee, however, was conditional on the
sale being forced by outside shocks like a divorce or the death of a spouse. It was offered in a
generally booming market and was in all likelihood used in very few cases.
Another example of a product directly tied to the value of an individual property is the shared
appreciation mortgage, offered by the Royal Bank of Scotland in the mid 1990s. This is a
mortgage loan where the lender agrees to an interest rate lower than the prevailing market rate
in exchange for a share of the appreciated value of the collateral property (settled at sale).
Offered in a booming market, shared appreciation mortgages were not ex post beneficial to
the borrowers and are not commonly available today.
In general it seems that products directly related to the price of an individual house will be too
expensive, or surrounded with too many special clauses, to be broadly attractive. Products
related to an index are likely to have more potential. A well publicized example of such a
scheme is a federally supported pilot project, called Home Equity Protection, started in
Syracuse, NY, in 2004; see Caplin et al. (2003) for a detailed description. Home Equity
Protection offers insurance against losses in market value from the date of house purchase to
sale, based on a zip code specific house price index. Insurance can be bought for an arbitrary
base value up to the purchase price of the house, i.e. the payment at the time of sale is equal to
the base value times the percentage index decrease during the holding period (or zero in case
of a price increase). Despite the careful design of this project, and the local indexes that it is
based on, it has not been a great success, perhaps because it was introduced in a booming
market, when households did not assign much probability to falling house prices.
6. The Future
The idea that index derivatives are useful devices for hedging residential house price risks has
been put forward by economists for a couple of decades. So far, however, one cannot point to
a single example of a successful launching of such instruments, neither as traded derivatives
12
nor as insurance products directly geared at households. Recent market developments – in
particular in swap contracts for commercial price indexes, but also the CME market in house
price derivatives – suggest that the time may now ripe for housing derivatives to succeed. So
it is worth asking what problems have to be overcome in order to make house price insurance
more widely available.
A key issue is whether households are really interested. Products offered have to meet specific
household needs. In principle, it would seem preferable with contracts that disentangle house
price risks from other risks like interest risks. In practice, however, it may be easier to sell
combined products, like index-linked mortgages for those who want to go short and indexlinked savings accounts for those who want be long in a housing market. Marketing is also
important. There are two natural channels: real estate agents and mortgage lenders. Perhaps
real estate agents may appear more neutral and could have larger credibility (at least today, in
the aftermath of the subprime mortgage crisis). For long contracts connected with savings
accounts, banks would appear to be the natural marketing channel.
Derivatives markets for professional actors and insurance contracts geared at individual
households should not be seen as competing solutions, but rather as complements. Financial
institutions offering home price insurance would need to hedge their risks. For a reasonably
balanced portfolio of contracts across submarkets, metropolitan wide futures or options
markets should offer good hedges. But in the absence of well functioning and liquid
derivatives markets insurance prices would have to include hefty risk premia, making them
less attractive to households.
Household interest would also depend on the relevance of the index. Traded derivatives are
naturally limited to rather few indexes covering large markets. Insurance products could be
tailored to much smaller areas, making them more attractive to individual households. But
relevance also depends on the quality of the index. This is related to the quality of the
underlying data. In many European countries, there is detailed public information about house
characteristics, making it possible to estimate good hedonic indexes. In the U.S., on the other
hand, only sales prices are available, making repeat-sales indexes the only viable alternative.
It is also desirable to maintain arms-length distance between the insurance provider and the
index producer. Ideally, the index should be produced by a government statistical agency. For
all these reasons, the preconditions for hedging markets are generally better in Europe. Even
13
so, there is an unavoidable conflict between index relevance and statistical precision. A broad
index can be based on many sales and hence be estimated with high precision but has limited
economic relevance. The narrower the index area is the fewer are the number of sales and the
more sensitive is the index to idiosyncratic variations in sales prices. The key question is
whether it is possible to strike a balance between the Scylla of a metropolitan or nationwide
index estimated with high precision and the Charybdis of a neighbourhood index excessively
sensitive to individual transactions.
14
Figure 1. Index of relative price of a residential house in Greater London versus Scotland,
1983= 100 (Source: Halifax index)
220
200
180
160
140
120
100
80
60
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
15
Figure 2. Efficient frontiers for homeowner with house value/ net wealth = 4 (Source:
Englund et al., 2002)
Efficient Frontiers For Renter with 40 quarter horizon
0.2
0.18
0.16
Expected Return
0.14
0.12
0.1
0.08
0.06
0.04
No Short & No Index
Short & Index
0.02
0
0
0.2
0.4
0.6
0.8
1
1.2
Risk: Standard Deviation
1.4
1.6
1.8
Figure 3. Efficient frontiers for renter (Source: Englund et al., 2002)
Efficient Frontiers For Poor Homeowner with 40 quarter horizon
0.2
0.18
0.16
Expected Return
0.14
0.12
0.1
0.08
0.06
0.04
No Short & No Index
Short & Index
0.02
0
0
0.2
0.4
0.6
0.8
1
1.2
Risk: Standard Deviation
1.4
1.6
1.8
16
References
Caplin, A., S. Chan, C. Freeman, and J. Tracy (1997), Housing Partnerships: A New
Approach to a Market at a Crossroads, MIT Press.
Caplin, A., W. Goetzmann, E. Hangen, B. Nalebuff, E. Prentice, J. Rodkin, M. Spiegel and T.
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