Dollars and Jens
Friday, November 03, 2006
Housing futures based on the Case Shiller indexes and traded on the Chicago Mercantile Exchange have predicted a decline in [housing prices in] the 10 markets around the country of 7.3 percent from August 2006 to August 2007. Prices in all 10 cities are projected to fall.


If the predicted decline happens, however, it may not be as severe as the futures trading indicates. According to Robert Shiller, the co-creator of the indexes, there is a risk premium to be taken into account; at this point, more traders are interested in protecting themselves against loss than are interested in buying into a growing market. That imbalance drives down the futures prices.
Any financial market has hedgers and speculators, and it is a maxim that, in a market with a persistently different mix on one side of the market than the other, the prices will tend to slightly favor the speculators over time. (This was noted by Keynes and Hicks — the latter of whom introduced the IS-LM model — as an argument for "normal backwardization", the idea that commodities futures should generally be lower than the spot price, on the theory that most hedgers are selling the futures.) This is simple risk-aversion — hedgers are willing to pay a bit of a premium to reduce their risk, and the marginal speculator will require a bit of a premium to take on the risk. The speculators are, to some extent, selling insurance to the hedgers, and, as Shiller is pointing out here, they kind of create the market in which hedgers are able to hedge their risks.

Not to get too far afield, but if one is called upon to distinguish trading in a financial market from gambling, I think the presence of hedgers is as good a way as any to do so. Financial markets are ultimately about risk transference, while gambling creates risks for everyone involved.

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