Market Mover - BNP PARIBAS - Investment Services India

This section is classified as non-objective researchEUR Gamma: Yet One More Carry Trade• In this environment, we still like bullishstrategies as leading indicators point to furtherweakness of the economic landscape.• Strategy: Buy 1x1.5 2.30% - 1.79 1y5yReceiver Spread versus 1x 4% 1y10y Payer, atzero cost.The upper-left corner of the swaption implied volatilitysurface currently looks rich versus delivered volatility(Chart 1). In particular, 1m2y and 1m30y straddlesare now trading respectively at 120% and 137% ofdelivered vol (one month window). Note though that,in the recent past, delta hedged long straddlepositions at the front end have been profitabledespite implied/realised ratios above unity: forinstance, in early August 3m2y implied volatility wastrading at a premium versus delivered volatility butlong convexity trading was profitable over a onemonthhorizon (Chart 2). In fact, at this point, volatilitydelivered more than what was priced in by impliedvolatility quoted one month prior. What happenedwas that given the backdrop of downside risk togrowth with CPI inflation significantly above the ECBtarget, increased uncertainty regarding monetarypolicy supported long vol positions at the front end.With the eurozone crisis still ongoing and the difficultposition in which Mario Draghi, the newly appointedgovernor of the ECB finds himself, we expect suchdynamics to re-emerge soon.In this environment, we still like bullish strategies asleading indicators point to further weakness of theeconomic landscape. In particular, we recommendclients enter the following carry trade:Buy 100m 2.30% 1y5y Receiver SwaptionSell 150m 1.79% 1y5y Receiver SwaptionSell 100m 4.00% 1y10y Payer Swaptionat zero cost.At the time of writing, the 5y swap is 2.02%, the 1y5yswap is 2.30%, the 10y swap is 2.63%, and the1y10y is 2.82%.The idea is simply to finance a long position in a 1y5yreceiver spread with short OTM 1y10y payer.Assuming the payer expires worthless, the followingholds: the maximum terminal profit is 1.83m if the 5yrate settles at 1.79%. Assuming unchanged 5y rate,the terminal profit is 840k. Finally the trade startsgenerating losses if the 5y swap settles below 1.01%Chart 1: Impl/Rls Ratios (1m)1y 2y 5y 7y 10y 20y 30y1m 127% 120% 117% 118% 121% 129% 137%3m 118% 113% 103% 105% 104% 110% 114%6m 106% 106% 99% 99% 99% 102% 103%1y 95% 99% 90% 90% 91% 92% 92%2y 100% 94% 83% 83% 84% 83% 83%Source: BNP ParibasChart 2: Evolution of 3m2y Impl/ForwardRls Vol versus Impl/Backward Rls Vol1.61.5Implied/Forward Rls Vol (1m)Implied/Backward Rls Vol (1m)1.41.31.21.11.00.90.80.70.6Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11Source: BNP ParibasChart 3: Mark to Market Valuation TodayAssuming Instantaneous ParallelShifts of the Curve500,0000-500,000-1,000,000-1,500,000-2,000,000-2,500,000Source: BNP Paribas-100 -75 -50 -25 0 25 50 75 100(the historical low being 1.70% seen in August lastyear).Six month carry P&L is worth 596k.The mark to market valuation today assuminginstantaneous parallel shifts of the curve is shown inChart 3.Matteo Regesta 27 October 2011Market Mover46www.GlobalMarkets.bnpparibas.com