(Reprinted from HKCER Letters, Vol. 11, November 1991) 


An Index Future for Property Prices

Ho Lok-Sang


The property market is well known for its cyclical behavior. Booms and busts characterize the property markets of all modern day economies. Like the markets for most other forms of assets, the market for properties is driven, among other factors, by expectation and speculation. Unlike the markets for other forms of assets, however, fluctuations in the property market cause much greater sways in emotions. In particular, a large drop in housing prices is interpreted to signal a serious economic slump. The government is often called on to revive the market. When housing prices rise rapidly, the government is also called on to curb speculation. Thus, in the wake of a spectacular surge in property prices, the government was under pressure to announce a series of measures to curb property speculation. In point of fact, however, the speculative instinct is such an important part of the market economy that stifling it would be tantamount to stifling the entrepreneurial spirit -- the drive to look for profitable opportunities and to act on them. Economists therefore typically warn against curbing speculation. Yet, there is no question that speculation can lead to higher property prices in the short term, and an abrupt end to a speculative boom can be painful and even disastrous.

Quite apart from the blunting of market instincts that was mentioned earlier, measures designed to curb speculation also have other undesirable consequences. Such measures as reducing the availability of financing or raising its cost, imposing heavier stamp duties or enforcing them on purchases made ahead of the completion of the building project, imposing penalties on rescindment or transfer of mortgages, etc., will no doubt raise the cost of speculation, but will inevitably hurt "genuine users" as well. Given that it is short-term speculation rather than long-term investment that is potentially disruptive of the property market, innovative measures to siphon off short-term speculation from the real property market seem to be in order.

Rather than directly intervening in the property market, short-term speculative activity can be channelled off to a property price index future market created for the purpose. Specifically, speculators can buy and sell these property price index futures much as they do now in the stock price index futures market. A separate price index future market can be envisaged for residential, office, retail, and for industrial properties. As long as we define the indices objectively, and in so far as they are updated regularly, the mechanics are strikingly similar to those with stock price index futures. The crucial requirement is that the indices should not be open to manipulation, and that they should be announced as soon as they are available, so that no one can get access to the information and take advantage of it ahead of others.

To use an example, suppose the housing index currently stands at 1000. The proposed index futures are available for four quarters, say with the first quarter ending on March 31, 1992. If the market is anticipating some price increase, and the first quarter index is traded at 1010, then for each contract, anyone who buys long will earn 1,000 dollars for every point rise in the index above 1010, while those who sell short will lose 1,000 dollars. The final settlement date for the first quarter of 1992 will be the date on which the latest price index for that quarter is released. The release date is timed to fall in April, and no trading in the first quarter index is permissible in April. This provision will guarantee that no unfair use of information will take place.

While the same provision will help minimize manipulation, to reduce it further we may exclude new housing projects in the construction of the price index, or we may use the prices of actually transacted houses in the secondary market(expressed in terms of dollars per unit area). The use of the median price for each category of properties to serve as the price index will also make manipulation difficult.

To see that there is a market for such price indices, it is necessary only to note that while buying and selling, property price index futures are subject to much lower transaction costs than buying and selling actual properties, but they present the speculator with much the same gains and risks. Any short-term speculation will likely, therefore, be siphoned off to this market, with the result that the prices of real properties will better reflect the sentiments of users and long-term investors. Because short-term speculators really have no reason to take long positions in both the index futures market and in the real property market, and they have every reason to take the long position only in the index futures market rather than the real property market, the disruptive effects of short-term speculation on real resource use and allocation will be avoided.

One important advantage of such property price index futures is that, unlike real properties, the supply of which may be quite inelastic in the short run, the supply of index futures is never subject to any physical limit. Property owners can hedge against price declines by selling short in the futures market, as can speculators who believe the market is about to enter a consolidation or retrenchment phase. Movements in the price index futures which are expected to lead real property price movements, provide useful signals to the real property market, with the result that with the creation of such a price index futures market, real property prices are less likely to overshoot in both directions.

Some people may think that the availability of the stock market property subindex futures may already serve the purpose of channelling short-term speculative activity away from the real property market. This is simply not true. Because stock prices are subject to many influences, many of which may not necessarily be tied to conditions in the property market, stock price index futures are a poor substitute for real property price index futures. The advantage of real property price index futures is that they enable buyers to reap profits truly commensurate with those reaped by property speculators.

There are, of course, technical problems that must be worked out in order to ensure orderly and fair trading of the index futures. One thing is certain: Activity in the proposed market will rise and fall with interest in property speculation. If speculative interest in the real property market is high, the proposed price index futures can be expected to trade actively, serving to channel the short-term speculation off the real market. If speculative interest in the real property market is low, activity in the proposed price index futures is also likely to be low. This does not matter, however, because it will have served us well in being active during the right times.

Dr. Ho Lok-Sang is a lecturer in the Department of Economics at The Chinese University of Hong Kong.


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