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

EUR: Yet Another Volatility Deflation Trade
• With the exception of severe dislocations at
the height of the credit crisis, the 10y10y skew
has undergone flattening and steepening
pressures with rising rates and falling rates,
respectively.
• STRATEGY: Buy the EUR 10y10y
3.50%-2.75%-1.00% swaption receiver ladder.
Historically, there has been a negative relationship
between the steepness of the swaption implied
volatility skew and the level of rates. This makes
intuitive sense: everything else being equal, at higher
levels of rates, deep out-of-the-money swaption
receivers are more attractive than deep out-of-themoney
payers. The opposite holds when rates are
low.
2.0
2.5
3.0
3.5
4.0
4.5
5.0
5.5
Chart 1: Evolution of EUR 10y10y Pay/Rec
Implied Volatility Spread
10y swap
6.0
2003 2004 2005 2006 2007 2008 2009 2010
Source: BNP Paribas
200bp out Pay/Rec Implied Volatility Spread (RHS)
Chart 2: EUR 10y10y Smile vs JPY 10y10y
Smile
6
4
2
0
-2
-4
-6
Chart 1 plots the long-term evolution of the EUR
200bp wide implied volatility spread against the
10-year swap. With the exception of severe
dislocations at the height of the credit crisis, the
10y10y skew has undergone flattening and
steepening pressures with rising rates and falling
rates, respectively.
It is worth comparing the current shape of the EUR
10y10y smile with its Japanese counterpart. Both
smiles are plotted in Chart 2: note the much steeper
JPY smile! It is worth highlighting that the twentyyear
range on the JPY 10y10y swap rate is between
1.39% and 4.18%. The current rate at 2.42% is still in
the first quartile. Clearly, if the Euro economy
continues to head towards a deflationary state, we
should expect the implied volatility skew to steepen
ahead.
Accordingly, in “EUR: Deflation Macro Hedge Via
Options” in this issue of Market Mover, we show two
downside macro deflation hedges via swaption
receiver spreads which generate positive PnL in the
event of a cheapening of the receiver skew.
Alternatively, the deflation risk can be played via
swaption receiver ladders which put additional weight
on the dynamics of out-of-the-money receivers. Chart
3 plots the terminal payoff of the EUR 10y10y
3.50%-2.75%-1.00% swaption receiver ladder (the
10y swap rate is currently around 2.89% versus the
10y10y swap rate at 4.14%). The trade costs 38bp
(indicative). At expiry, the trade generates losses if
the 10y swap settles below 30bp! For comparison the
JPY 10y swap attained its all-time low of 43bp mid-
June 2003. More importantly, the position carries
1.20%
1.10%
1.00%
0.90%
0.80%
0.70%
0.60%
0.50%
0.40%
EUR 10y10y smile
JPY 10y10y smile
0.30%
0% 1% 2% 3% 4% 5% 6% 7% 8% 9%
Source: BNP Paribas
7.0
6.0
5.0
4.0
3.0
2.0
1.0
0.0
-1.0
-2.0
-3.0
Chart 3: Terminal Payoff of EUR 10y10y
3.50%-2.75%-1.00% Receiver Ladder
-4.0
0.00 1.00 2.00 3.00 4.00 5.00
Source: BNP Paribas
positively with the expected total return over the
coming year (next two years) estimated at around
8% (22%). Exposure to the skew dynamics is
reflected by SABR Rho around EUR 10,000.
Terminal max pay-out ratio is 1:14.
Matteo Regesta 16 July 2010
Market Mover, Non-Objective Research Section
30
www.GlobalMarkets.bnpparibas.com