Market Outlook - BNP PARIBAS - Investment Services India

US: After FOMC, Favour Calls on Front End
• In light of the FOMC statement, outright
front-end carry positions no longer look as
attractive since the market could be spooked
by strong data and aggressively push frontend
rates higher.
• We still feel the Fed won’t hike any time
soon and have long recommended playing the
base-case scenario of a Fed on hold using
options. This takes advantage of the outsized
rolldown in the short end.
• STRATEGY: Buy 6m1y and sell 6m10y
receivers in a costless structure to take
advantage of a highly attractive entry point due
to the flatter forward curve and historically
cheap vol ratio.
Chart 1: 6m1y/6m10y 50bp OTM Vol Ratio
160%
140%
120%
100%
80%
60%
40%
Jan-04 May-05 Sep-06 Feb-08 Jun-09
Chart 2: Entry Level Compared to Spot 1y10y
350
The trade is a conditional bull-steepener although the
outsized carry at the front end is the main impetus for
the trade. We sell the 6m10y receiver around 75bp
out of the money so as to strike it at 3.30%, some
50bp below spot and the lowest level on the 10y rate
in recent months. While we expect this to fall out of
the money, the 6m1y receiver can be expected to
end up in the money. To make it costless, the 6m1y
receiver can be struck at around 0.64%, which
compares favourably with the spot 1y range of 0.43-
0.67% in recent months.
From a curve perspective, the credentials are very
strong, since the effective curve strike is 266bp. The
spot 1y10y is currently trading at 330bp and has
been above the entry level since May last year (see
Chart 2 for 3m and 6m breakeven floors). The risk to
the position is deflation concerns or a number of
economic setbacks which could bull-flatten the curve.
Chart 3 shows the expect P/L under curve
movements in 1y10y which are led by the 10y (as per
current market dynamics, the 1y is relatively pegged
while the 10y leads). In a sell-off, the position can
actually be expected to be in the black. The current
market environment suggests that the 10y will lead
the sell-off, so the receiver we are short will
depreciate faster than the receiver we are long. In a
300
250
200
150
3m Floor
6m Floor
100
Jan-09 Apr-09 Jul-09 Oct-09 Jan-10
Chart 3: Expected P/L Under Curve Movements
400,000
300,000
200,000
100,000
-
(100,000)
(200,000)
(300,000)
6m Holding
(400,000)
3m Holding
(500,000)
-75 -50 -25 0 25 50 75
All Charts Source: BNP Paribas
1y10y Curve Changes
bear-flattening scenario, the receivers simply fall out
of the money.
Table 1: Trade Details for 6m1y vs 6m10y Conditional Bull-Steepener
Structure Strike Notional ($) PV ($) PV01 ($) Vega ($) Gamma ($) Theta ($)
Buy 6m1y Rec F - 43bp 200,000,000 125,000 5,133 31,829 1,149 (1,197)
Sell 6m10y Rec F - 75bp (24,000,000) (125,000) (3,494) (39,456) (651) 1,566
Net 0 1,639 (7,627) 498 369
Source: BNP Paribas
Suvrat Prakash 29 January 2010
Market Mover, Non-Objective Research Section
28
www.GlobalMarkets.bnpparibas.com