MARKET MOVER - BNP PARIBAS - Investment Services India

We are comfortable with the directional exposure
given our bullish view into year-end, although one
could buy less notional in 4y1y to account for this.
We choose to use receivers rather than straddles
because this helps the position trade ‘conditional’ on
a scenario of low rates. The position would still be
underwater in a near-term selloff, although the
sensitivity of the position would drop. Finally, we
choose to strike the receivers 50bp below the
forwards so that after one year the strikes are closer
to the forwards, making it easier from a liquidity
standpoint to get out of the position.
The additional features that make us favour this
position stem from the asymmetric risks we see in
the yield spread and relative realised vol between the
two rates. Simply put, if we stay around these rate
levels or go lower, then the closer forward rate
runs out of room to rally and the further-out
forward rate performs relatively better. Chart 4
shows that the 2y1y/4y1y spread is near the top end
of its historical range and so the risk from this
perspective is tilted toward a tightening.
The Japan experience (or at least the beginnings of
it) can provide a useful historical perspective. The
BoJ cut rates to 0% for the first time in 1999, after
which the 1y1y rate soon bottomed out and traded
sideways for several years. Meanwhile, the 3y1y rate
continued to rally and the spread compressed (see
Chart 5).
Another way to look at it is from a vol performance
perspective. While the 1y1y rate in Japan was
trading sideways, the ratio of 3y1y realised vol over
1y1y steadily picked up (see Chart 6).
Chart 4: 2y1y/4y1y Rate Spread Near the Highs
200
150
100
50
0
2y1y vs 4y1y USD Rate Spread
-50
Jan-99 May-01 Sep-03 Jan-06 May-08 Sep-10
Chart 5: After Japan Cut Rates to 0%, the 3y1y
Continued to Rally While 1y1y Went Sideways…
2.5
2.0
1.5
1.0
0.5
0.0
Jan-96 May-97 Sep-98 Feb-00 Jun-01 Nov-02
2.5
1y1y JPY Rate
Spread of 1y1y/3y1y JPY Rates (right scale)
Chart 6: …Meaning That 3y1y Realised Vol
Vastly Outperformed 1y1y
1y1y JPY Rate
250
200
150
100
50
0
600%
2.0
1.5
1.0
0.5
3y1y Realized Vol over 1y1y
Realized Vol (right scale)
500%
400%
300%
200%
100%
0.0
Jan-96 May-97 Sep-98 Feb-00 Jun-01 Nov-02
0%
All Charts Source: BNP Paribas
Table 1: Trade Details and Greeks
Structure Strike Notional ($) PV ($) PV01 ($) Vega ($) Gamma ($) Theta ($)
Sell 2y1y Rec F-50bp (100,000,000) (220,000) (3,854) (35,996) (251) 385
Buy 4y1y Rec F-50bp 100,000,000 495,000 4,082 63,014 187 (348)
Net 275,000 228 27,017 (64) 36
Source: BNP Paribas
Suvrat Prakash 23 September 2010
Market Mover, Non-Objective Research Section
22
www.GlobalMarkets.bnpparibas.com