Derivative News - Nicholas Scott

Cap bids meet dwindling supply,
positioning and illiquidity
Buying of caps in the 5y
to 10y area is repeatedly
touted as one factor driving
vega north. This buying has
gathered since at least the
summer but the root
of market moves goes
back to 2008.
At present, European corporates and
other customers favour buying caps
as a natural inflation hedge and an
alternative to inflation protection than
more expensive swaps. Cap bids out
to the 5-7y area are said to be linked to
mortgage demand from Spain, Italy and
Germany. As new, capped mortgages
are issued due to the rate environment,
these accounts cover themselves by
buying caps, for instance. In a low
for long rate environment, this sort of
organic demand is likely to persist,
and traders see it sticking if rates head
further south.
The bids in caps have focused on the
5X10 CFS area and moved the wedge
against the 5y5y swaption straddle up
to around 170bps peaks about a week
ago. Back in Autumn 2008, this wedge
got down to 38bps.
Part of these moves are explained
by traders believing previous cap
pricing was too cheap. This summer,
one trader described the process of
wedge normalisation as not surprising,
reasoning that “when you put it into
any ‘sensible’ model, then you see
caps looked really cheap. People are
starting to realise that the models were
just wrong before… I’d say the term
structure of cap/floors could go up ad
infinitum. There’s a long way for it to go
before it looks rich in any model.”
At the same time, the moves in the
wedge reflect the market hedging
supply it took on after Lehman’s
positions were auctioned by LCH.
Clearnet in late 2008. At the time, the
street became even longer cap vol due
to these additional positions, which
whacked the wedge down to 38bps.
Since then, this long position has been
hedged and the street is now thought
to be short.
“It’s clear there’s been a large amount
of cap buying. After Lehman, dealers
were long through structured products
like rangers and even Bermudans
and they got even longer taking on
Lehman’s book. But dealers have been
taken out and now they’re short,” said
a trader.
Short market positions exacerbated the
impact of cap bids. Several sources
describe the market running a short
cap position for some time, with a
general reluctance for exiting that
position further fuelling the move higher.
“A lot of people are warehousing short
cap positions. They didn’t realise
the position was so crowded. Short
covering has made the market move
even more,” said a source.
From the supply side, range accruals
have dwindled while inflation
expectations mount. This has
removed potential cap vol offers and
compounded inflation concerns that
drum up cap vol bids. “There’s a
lack of range accrual hedging, With
the ECB starting to buy government
bonds, people in Germany worry about
inflation in 5y time so they buy caps,”
said another source. “Demand from
these traditional end users (of caps)
isn’t being offset by supply from range
accruals.”
Last but not least, market illiquidity
further distorted levels and has proved
to be a big driver in thin markets with a
looming year-end. “Everything is being
driven by liquidity. The market is just so
illiquid that it has a hard time absorbing
200m,” said one trader.
Indeed, as the cap appetite faces an
illiquid and risk-averse market, moves
are proportionally large. “There is zero
risk appetite and clients are buying
caps. A 100m client trade is enough to
push the 5X10 up another 10 ticks, so
I think people are just hedging as they
go,” said another.
03 Q3 – Q4 2010