Default Risk and Real Estate Prices: The Use of Index- Based Futures and Options in Real Estate

Abstract:     
This article makes the case for using index-based futures and options driven by region-specific movements in house prices as the basis for hedging mortgage default risk. Taking the view that mortgage holders write put options on real estate assets, the first part of the article lays out the theoretical case for a hedging strategy based on house price changes. The second part reviews the empirical literature on default risk and uses data from the Mortgage Bankers Association of America and repeat sales indices to test for the significance of house price movements in predicting mortgage default.The results suggest that between 1975 and 1993, periods of high default rates strongly follow real estate price declines or interruptions in real estate price increases. The relation between price declines and foreclosure rates is modeled using a distributed lag. The results support the case for a hedging strategy based on house price changes.

JEL Classifications: D46, G13, G21

Accepted Paper Series