Market Outlook - BNP PARIBAS - Investment Services India

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This section is classified as non-objective researchEUR: Forward Vol is Cheap• Risk aversion is supporting implied volatilityand exerting downward pressure on the slopeof spot implied volatility term structures. In turn,inverted spot volatility term structures havepushed forward volatilities to attractive buyinglevels.• Strategy: Buy 1y10y5y via a swaptiontriangle.Chart 1: 5y Swap Forward Vol Term StructuresCharts 1 and 2 show forward implied volatility termstructures modelled using a Hull-White basedmodelling approach. Indeed, forward volatility ismodel dependent with price being a function of futureATMF dynamics and smile rolling effect on thehedged forward straddle. In the charts the forwardlag is on the x-axis and implied volatility is on they-axis. The starting points of the curves ("spot" labelon x-axis) show standard (spot) implied volatilities.Source: BNP ParibasChart 2: 20y Swap Forward Vol Term StructuresThe charts illustrate the curves that are the mostinteresting currently, limiting the analysis to 1yforward volatilities’ attractive cheap forward points,which can be sensibly replicated (purchased) viaswaption triangles.On the 5y underlying, the sweet spot is the 1y10y5y(i.e., 10y5y implied volatility 1 year forward): the pointis 39bp cheaper than 10y5y implied volatility! Thisspread is clearly an accurate measure for the carry ofthe position. Analogously, on the 20y underlying, thesweet spot is the 1y6y20y point, which is 39bpcheaper than spot.Source: BNP ParibasChart 3: Breakdown of Forward Straddle intoThree Spot StraddlesForward swaption straddles as an asset class arecurrently not liquid/traded. However, they can bereplicated via swaption triangles (for more details,see “Forward Volatility for the Practical Man”,released in October). The basic idea is depicted inChart 3. For instance, the 1y10y5y straddle can bebroken down into the following three vanillastraddles:L: 1y15yS: 1y10y0Source: BNP ParibasLT Ts TeSUU: 11y5yAssuming the implied correlation between 1y10y and1y15y rate equals 1, it can be shown that therequired weights to replicate 100m notional on1y10y5y are w(L) = -63.4m, w(S) = 63.1m and w(U) =117.3m.Matteo Regesta 20 October 2011Market Mover38www.GlobalMarkets.bnpparibas.com
This section is classified as non-objective researchJGBs: Buy 2y2y Payers• JGBs have been trading robustly despite therecent moves in the EGB market. With JPY volsin short tails suffering from the collapse inrealised vols, buying OTM payers looksattractive.• STRATEGY: Investors looking for a sell-offin JPY rates should buy OTM 2y2y payers.30025020015010050Chart 1:5y Sov CDS (bp)Italy France JapanGermany UK USASell Japan?JGBs and JPY IRS have been trading in a relativelytight range compared with moves in overseasmarkets. Recently, the European sovereign debtcrisis has pushed yields higher for AAA countriessuch as France, but Japan’s credit seems to beconsidered a safe haven even though the 5y CDShas traded above 100bp.A common ‘sell Japan trade’ has been to buy payerson 10y tails. However, comparing EGB yields againstEUR IRS as a proxy of an average EUR rate revealsa massive bear-flattening trend given the rise in riskpremiums. This means there is more leverage inforward short rates as the change in the forward rateis roughly calculated from the change in the outrightlevel and the change in slope.Chart 3 shows the relative richness of 10y tailsversus 2y tails. This uses eight years of historicaldata of the ATM fwd rate (x-axis) versus the ATMnormal volatility observed relative to each ATM fwdrate. The orange square represents the current level.The red triangle illustrates the breakeven level with a1% strike. Thus 2y2y vol is relatively inexpensive,and in line with the current trend (in the green cloud).If you do the same exercise for the 2y10y, the graphlooks totally different (shown underneath),highlighting the richness of 10y tails.Moreover, the JPY vol curve is still flat in this lowyieldenvironment as the short tails are suffering fromthe sell-off in realised vol.Trade ideaOur central scenario does not include a crash ofJGBs. However, investors looking for a ‘sell Japantrade’ should look to buy OTM 2y2y payers at currentlevels as a cheap way of expressing this view. If youset the strike at 1%, our indicative offer is at 14.02008 2009 2010 2011 2012Source: BNP Paribas20181614121086420Chart 2: EGB Yields and Swap Rates (%)EUR Swap France SpainItaly Ireland PortugalGreece (RHS)1 2 3 4 5 6 7 8 9 10 (Year)Source: BNP Paribas908070605040302010090807060504030Chart 3: ATM Fwd versus Implied VolNorm. Vol, bp2y2yATMF, %0.0 0.5 1.0 1.5 2.0 2.5 3.0Norm. Vol, bp2y10yATMF, %1.0 1.5 2.0 2.5 3.01009080706050403020100Source: BNP ParibasTomohisa Fujiki 20 October 2011Market Mover39www.GlobalMarkets.bnpparibas.com
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