Market Economics | Interest Rate Strategy - BNP PARIBAS ...

US: 10y Range Trade with a Receiver Fly
• Investors are increasingly comfortable with
the prospect of the 10y rate hovering around
3% in the near term, without a strong
directional trend.
• The range trade lends itself to selling
volatility, but there is a strong preference to
limit the downside in any trade.
Chart 1: 10y Swap Rate and the Breakeven
Levels of the 3m10y Swaption Fly
4.5
4
3.5
• STRATEGY: Buy a 3m10y receiver fly,
struck ATMF+15bp, ATMF-10bp, ATMF-35bp.
The maximum payout ratio is 3.6:1.
3
2.5
Breakeven levels
2
With the economic reports showing a slowdown in
the pace of recovery lately, there is a broader
acceptance of the spectre of low rates not just in
terms of monetary policy but also in terms of term
rates. With the risk of ever lower inflation down the
road, it appears rather unlikely that rates will spike
higher in the next few months. Nor is there much
chance of a strong rally from current levels absent a
flight-to-quality event, as investors find it difficult to
stomach a sub-3% rate on 10s and sub-4% on 30s –
after all, the deflationary mindset is slow to seep into
the collective consciousness. This backdrop bodes
well for range trades, and as an extension, for selling
volatility.
Being cognisant of the strong preference investors
have for trades with a well-defined downside, we
analyse swaption butterflies (rather than selling
strangles, or 1x2 trades) to express the range-trading
view. The idea is to buy a butterfly that brackets the
most recent range of the underlying rate. Scouring
the field for a good combination, we find that the 10y
tail offers a good opportunity, especially with 3m and
6m expiries. While the premise is the same and the
6m trades have a higher expiry payout ratio, the 3m
version is preferable in our opinion, thanks to the
speed at which the payout can be realised over the
next three months. More specifically, we recommend
buying the ATMF+15bp, ATMF-10bp and ATMF-
35bp 3m10y receiver fly (the centre leg, ATMF-10bp,
is chosen to match 10y spot to mitigate any
directional bias in the trade).
Chart 1 shows the recent range of the 10y swap rate.
The breakeven levels of the butterfly trade, also
shown on the same chart, cover the range that had
prevailed since the downward adjustment of the
prognosis for US economic growth and inflation,
along with rate hike expectations, began in June. It is
clear from the chart that the upper breakeven level
7/15/09
8/15/09
9/15/09
Source: BNP Paribas
10/15/09
11/15/09
12/15/09
Chart 2: Performance of the Fly over Different
Horizons (in bp)
200
150
100
50
0
-50
-100
sits at the bottom of the rate range before that
change in outlook. More to the point, that level acted
as a floor for rates when the economy was perceived
as recovering handsomely. Given that the 10y rate
has broken that support level and seems to have
settled into a lower range, it is conceivable that it will
break back up to the upside unless the macro picture
changes materially.
Chart 2 shows the PnL of the trade over different
horizons, expressed in bp. At inception the cost of
the structure is 48bp. For reference, at expiry the
trade can generate about 171bp of profit, which
translates to a 3.6:1 payout ratio.
1/15/10
-30 -20 -10 0 10 20 30
Source: BNP Paribas
2/15/10
3/15/10
4/15/10
now
2m
5/15/10
1m
6/15/10
expiry
Bulent Baygun 16 July 2010
Market Mover, Non-Objective Research Section
21
www.GlobalMarkets.bnpparibas.com