MARKET MOVER - BNP PARIBAS - Investment Services India
MARKET MOVER - BNP PARIBAS - Investment Services India
MARKET MOVER - BNP PARIBAS - Investment Services India
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US: A Carry Trade with Extra Potential<br />
• After the FOMC statement, the question<br />
arises once again about a Japan-like scenario.<br />
• We explore a carry trade with a few added<br />
kickers in case the swap and vol curves start<br />
to evolve the way they did during the<br />
beginning of Japan’s experience.<br />
• STRATEGY: Buy 4y1y vs selling 2y1y<br />
receivers, both 50bp OTM and equal notionals.<br />
Holding period is up to one year.<br />
As the front end continues to richen, the carry on<br />
offer keeps getting compressed. What should one<br />
do, since the latest FOMC statement reinforces the<br />
idea that this strategy can still be profitable?<br />
One approach would be to analyse various different<br />
long positions and hunt down the best carry or alpha.<br />
Another approach we explore here is to find a<br />
rolldown strategy that has a few added kickers in<br />
case the vol surface and swap curve start to evolve<br />
the way they did during the beginning of Japan’s<br />
experience.<br />
Rather than simply buying receivers, the trade is to<br />
buy 4y1y vs selling 2y1y receivers (both 50bp OTM,<br />
same notionals). This way, one can capitalise on<br />
the spread between these two forward rates and<br />
also the vol ratio, if we stay mired in the low rate<br />
environment for a while. As we show later, this is<br />
where we see the asymmetric risk that helps the<br />
trade when considering the beginning of Japan's<br />
experience.<br />
Table 1 shows the exact trade details and greeks.<br />
The current entry cost is 27.5c and after one year<br />
the position gains 40% (see Chart 1 for PnL<br />
profile). The rolldown is partly due to positive theta,<br />
but mainly due to the 2y1y leg having a steeper vol<br />
rolldown than the 4y1y. Chart 2 shows that the<br />
2y1y/4y1y vol ratio of around 90% drops sharply to<br />
70% after one year. In Japan, the ratio is 50%.<br />
Since the 4y1y rate is currently 10-20% more volatile<br />
than 2y1y, this makes the position trade like a long<br />
on the market since the 4y1y receiver leg will move<br />
more. Another feature which makes the trade<br />
directional is that the vol ratio tends to fall in a rally –<br />
helping the position – while rising in a selloff (see<br />
Chart 3 for relationship).<br />
250%<br />
200%<br />
150%<br />
100%<br />
50%<br />
0%<br />
Chart 1: PnL Profile Under Rate Shifts<br />
1y Holding<br />
Instantaneous<br />
-50%<br />
-75 -50 -25 0 25 50 75<br />
Change in 5y Rate (with beta-implied curve movement)<br />
Source: <strong>BNP</strong> Paribas<br />
Chart 2: Sharp Rolldown in Vol Ratio over 1y<br />
140%<br />
130%<br />
120%<br />
110%<br />
100%<br />
90%<br />
80%<br />
70%<br />
2y1y over 4y1y USD Vol Ratio<br />
1y1y over 3y1y USD Vol Ratio<br />
60%<br />
Jan-06 Dec-06 Nov-07 Oct-08 Oct-09 Sep-10<br />
Source: <strong>BNP</strong> Paribas<br />
Chart 3: Vol Ratio has been Directional to Rates<br />
110%<br />
105%<br />
100%<br />
95%<br />
90%<br />
85%<br />
Jan-10 Feb-10 Apr-10 May-10 Jul-10 Sep-10<br />
Source: <strong>BNP</strong> Paribas<br />
2y1y over 4y1y USD Vol Ratio<br />
4y1y USD Rate (right scale)<br />
5.0<br />
4.5<br />
4.0<br />
3.5<br />
3.0<br />
2.5<br />
2.0<br />
Suvrat Prakash 23 September 2010<br />
Market Mover, Non-Objective Research Section<br />
21<br />
www.GlobalMarkets.bnpparibas.com