MARKET MOVER - BNP PARIBAS - Investment Services India

This section is classified as non-objective research
What Are the Trades?
With an eye towards finding the time frame that
contains the largest amount of projected rate hikes, or
the highest risk premium for rate hikes, we look at the
term structure of 1yr rates on various forward dates.
The biggest jump in 1yr rates is between years three
and four, as shown in Chart 2. In other words, the 4y1y
rate offers the best rolldown, at 60+ bp over one year,
with the 5y1y coming in a close second. This area is the
sweet spot for rolldown and suggests one of two
strategies: 1) receive the 4y1y (or 5y1y) rate outright; or
2) initiate a 3y1y/4y1y flattener (or a 4y1y/5y1y
flattener). Note that the 1yr rolldown of the 4y1y is the
entry level for the 3y1y/4y1y position, etc. However,
keep in mind that despite the attractive rolldown, there
is considerable directional risk in the former trade in the
event that the market gets caught in a frenzied
response to some positive developments. As for the
curve trade, the entry level is not exactly very attractive
in historical terms, and the rolldown of the 3y1y/4y1y
flattener (i.e., the difference between the 1yr rolldown of
the 4y1y and 3y1y positions) is a less-than-compelling
15bp over one year and is negative for the 4y1y/5y1y
flattener (see the second set of bars in Chart 2).
On the other hand, the strong rolldown in the 4y1y and
5y1y rates does suggest a compelling option trade using
receivers. As vol is cheaper on the 4y1y, we will focus on
that structure. Chart 3 shows that the vol-adjusted
rolldown of the 4y1y structure is very attractive compared
to where it has been in the past. Much more to the point,
thanks to the strong rolldown, the 4y1y receiver
appreciates in value as it ages, indicating that the
rolldown effect outweighs the time decay. Therefore, one
gets paid to stay in the position, even in the absence of
any rally in the interim. In short, buy the 4y1y as a
prudent way to express the view that too much Fed
tightening has been priced in too soon in the 4 to 5yr
sector. Table 1 shows the potential returns for the
receiver over a one-year horizon under various rate
scenarios.
Chart 4: Has The Curve Steepened to an Extreme
in the 8yr to 10yr Sector?
40
7
(bp) 9y1y - 8y1y (LHS) (%)
30
20
10
0
-10
-20
00 01 02 03 04 05 06 07 08 09 10 11 12
Source: BNP Paribas
Fed Fund Target
Table 1: Rolldown Offsets Time Decay in the 4y1y
Receiver (1yr Horizon)
Change in
Yields -25bp -15bp Unchanged 15bp 25bp
Return 73% 56% 33% 12% -0.5%
Source: BNP Paribas
Last, if you notice in Chart 2, the 8y1y/9y1y flattener
currently trading at about 20bp has very small negative
rolldown as it ages over one year into a 7y1y/8y1y
position. While the premise of a flattener so far out on
the curve would not really be based on mispriced rate
hike expectations, one thing that stands out is that, for
some reason, this part of the curve is almost as steep
as it was heading into and through the last tightening
cycle (see Chart 4). Therefore, from a pure valuation
perspective, we argue that being in the 8y1y/9y1y
flattener offers a good risk/return proposition, giving
low-cost exposure to a bull-flattening of the curve in
case the growth outlook disappoints or Europe flares up
again. This is not a trade that will make your year, but it
could easily move 5-10bp in your favour without
threatening much downside.
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Bulent Baygun 20 September 2012
Market Mover
23
www.GlobalMarkets.bnpparibas.com