Abstract
We analyze household hedging costs and market liquidity of exchange traded options on a set of well-developed U.S. home price indexes allowing homeowners to hedge the downside risk of housing prices. We estimate empirically the impact of hedging costs on market liquidity of housing derivatives using prices from Case–Shiller Home Price Index (CSI) futures options and Barone-Adesi and Whaley [Efficient analytic approximation of American option values. J. Finance, 1987, 42, 301–320] simulations. We find that hedging costs significantly affect household savings resulting from hedging. We propose a new cost-based illiquidity measure for housing derivatives and link it with traditional contract-based liquidity measures in thinly traded derivatives markets. We document a negative relation between savings from hedging and our cost-based illiquidity measure. We further perform a series of robustness checks. Overall we suggest that the liquidity of exchange traded housing derivatives could benefit U.S. homeowners.
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