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

EUR: Buy 3m5y Straddle vs 3m10y Straddle
• The 3m5y/3m10y implied volatility ratio is
currently hovering around 0.97, having almost
monotonically increased from around 0.86 in
mid- December
• We expect the implied ratio to increase
further. Also, we expect gamma 5y options to
deliver more volatility in the context of
heightened concern over inflation.
• STRATEGY: Buy 3m5y straddle vs 3m10y
straddle.
Table 1: Implied/Rls vs (3M)
1y 2y 5y 7y 10y 20y 30y
1m 147% 115% 115% 113% 112% 112% 111%
3m 131% 119% 103% 112% 110% 111% 109%
6m 115% 119% 107% 108% 107% 108% 105%
1y 115% 115% 104% 104% 101% 100% 97%
3m5y implied volatility is hovering around 85bp
whereas 3m10y implied volatility is around 88bp.
Indeed, the 3m5y/3m10y implied volatility ratio is
hovering around 0.97, having almost monotonically
increased from around 0.86 in mid-December
In the meantime, 3m5y volatility is currently
delivering more than 3m10y volatility over a threemonth
horizon (Table 1). At the ECB’s January press
conference, there was a hawkish shift in the
assessment of inflation risk. After some dovish
remarks by the ECB’s Orphanides, expectations
have stabilised at one 25bp rate hike by year-end.
However, the debate on inflation in the eurozone is
gradually taking centre stage. At the current level of
rates, the risk of the market pricing in a tighter
monetary policy in the short term is significant, in our
view. In fact, the latest hawkish comments by ECB
Stark on Wednesday are telling. In his view, both “the
global economy and the Euro region recovered faster
than thought”, and it is “important that the emergency
measures remain temporary”. Against this backdrop,
we expect the 5y swap to deliver more volatility than
the 10y going forward. Accordingly, we like long
(dynamic) gamma positions on the 3m5y point vs the
3m10y point.
Source: BNP Paribas
Chart 2: 3m5y/3m10y Implied Vol Ratio vs Refi
5
4
3
2
1
0
Jan-
05
Jul-
05
Refi
Jan-
06
Source: BNP Paribas
EUR 3m5y/3m10y Implied Vol Ratio (RHS)
Jul-
06
Jan-
07
Jul-
07
Jan-
08
From a vega risk perspective, a further increase in
the 3m5y/10y ratio is consistent with a higher interest
rate regime and/or monetary policy normalisation by
the ECB (Chart 1).
Table 2 shows our preferred trade construction for a
long position in the 3m5y/3m10y swaption spread.
Jul-
08
Jan-
09
Jul-
09
Jan-
10
Jul-
10
1.4
1.3
1.2
1.1
1.0
0.9
0.8
Jan-
11
Table 2: Trade Construction
Notional
Implied
ATMF rate Premium PV PV01 Gamma Vega
(EUR mn)
Vol
BE vol Theta/d Theta (EUR)
Buy 3m5y Straddle 186 2.81 156 2,897,936 4,581 16,636 291,451 85 5.4 -1.2 -22,602
Sell 3m10y Straddle -100 3.43 290 -2,898,583 -2,942 -15,581 -291,228 88 5.5 2.3 22,607
-647 1,639 1,056 223 5
Source: BNP Paribas
Matteo Regesta 20 January 2011
Market Mover, Non-Objective Research Section
47
www.GlobalMarkets.bnpparibas.com