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Original headline: Popular protection

Author: Mark Pengelly

Source: Risk magazine | 01 Nov 2010

Categories: Inflation Derivatives

Topics: Pimco, Treasury Inflation-Protected Securities (Tips), Asset swaps, US inflation options, Inflation


 

       

  

      

  

      
   
          
 



 
  
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Markets are uncertain. There are some participants who believe the last dregs of the current round of government economic
stimulus will push inflation higher - a fear reinforced by recent signs the US is preparing a fresh burst of quantitative easing. Then
there are those who worry about a double-dip recession and see deflation as the major risk. And it is this latter fear that has been
the driving force in the inflation options market for much of this year.

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ÿThe market has reflected the fact that no-one has really thought about the risk of high inflation. Last year there was more worry
about high inflation than there has been for much of this year,ÿ says Benoit Chriqui, head of European inflation trading at B arclays
Capital in London.

Despite signs of a global economic recovery in 2009, inflation has remained subdued in many jurisdictions. In the US, the
consumer price index (CPI) was reported at 0.9% in June last year, but has remained within a band of -0.2% and 0.4% between
July 2009 and September 2010.

Signs of sluggish economic growth for much of this year have heightened fears of a slide into deflation, prompting a number of
participants to look for hedges against a worst-case scenario. For some, the answer has been to purchase low-strike inflation floors
- in many cases, for the first time. ÿ e hadn't seen that much buying of high-strike caps, which are typically a product people will
buy if they are worried about high inflation, but there has been an increase in interest in floors,ÿ says Chriqui.

This demand, combined with uncertainty about the future path of inflation, has pushed the price of floors higher since the
beginning of the year. Ten-year zero-coupon 0% floors on US CPI rose from 72 basis points on January 1 to hit a peak of 159bp
on September 2, according to Bloomberg. Similarly, 10-year zero-coupon 0% floors linked to the European harmonised index of
consumer prices (HICP) climbed from 13bp at the start of the year to hit 133bp on August 26.

Insurance companies and pension funds have been among the most active buyers of floors. hile many may think prolonged
deflation is unlikely, these investors are keen to hedge against a deflationary spiral, similar to that seen in Japan in the 1990s, say
dealers. ÿThese clients need protection against very low-probability events - ones that nobody is expecting. They are thinking
about and hedging the lost-decade scenario,ÿ says Dan Haehnel, Paris-based inflation exotics trader at Société Générale Corporate
and Investment Banking (SG CIB).

Buyers of downside protection might already be long inflation and looking to hedge an underlying swap portfolio - and some
pension funds are required to buy floors to hedge their downside, says Haehnel. ÿSome people who have done a lot of swaps with
market-makers are trying to floor their swaps at zero. One possibility of the massive flows is that there is some kind of legal
aspect that obliges the long inflation swap investor to protect their swaps.ÿ Pension funds have been particularly keen buyer s of
10-year and 30-year 0% floors, he adds.

Nonetheless, one of the most prominent sources of demand for 0% floors this year has been a single client. During the first six
months of 2010, Toronto-based insurer Fairfax Financial purchased deflation protection worth $21.539 billion in notional, paying
$173.7 million in premium, according to the firm's second-quarter financial statements. The 10-year zero-coupon 0% options were
spread across dollars, euros and sterling.

Dealers say the Fairfax trades have had a substantial impact on the market, with implied volatility rising across vario us maturities
along the curve. ÿThe behaviour of all market participants changed because of this flow. There was a scarcity on the 10-year zero-
coupon 0% floor, so some people were trying to buy back five-year, seven-year and 12-year options, and all the other points close
to it,ÿ says Haehnel at SG CIB.

A large slice of the dollar notional from the trade was sourced from California -based fixed-income manager Pimco. In a
regulatory filing dated August 27, the firm revealed it sold more than $8 billion in no tional of 10-year zero-coupon 0% inflation
floors. The floors were sold in return for more than $70 million in premium, with Citi and Deutsche Bank acting as counterpar ties
to the trades.

For Fairfax, the purchase of the floors reflects nervousness about the prospect of a Japan-like scenario or a repeat of the Great
Depression, says Paul Rivett, Toronto-based chief operating officer of investment management at the firm. ÿ e try to take a
historical perspective and look at these things, and we're quite concerned about the impact deflation has on the economy. It's
corrosive to just about every type of investment in every jurisdiction and in every asset class. e're not saying deflation i s going
to happen, but we have identified it as a risk and we're not the only ones who have identified it as a risk,ÿ he remarks.

High inflation is less of a concern for the firm, as it is not felt to be as damaging to its investment portfolio. ÿThere may be
inflation, but inflation is not as corrosive, so we don't have the same concerns about it,ÿ adds Rivett. By the end of June 2010,
Fairfax had recorded a mark-to-market gain of $58.8 million on the contracts.

Pimco could not be reached for comment. However, dealers say it is easy to see why the trade made sense for the company. It
holds a large portfolio of Treasury inflation-protected securities (Tips), which contain embedded 0% floors. The firm was
therefore able to monetise this long deflation floor position and take advantage of the high levels of volatility.

ÿIt was a sensible fit. They're long those deflation floors in their Tips portfolio. They're generally bullish on inflation, so they don't
foresee this deflationary scenario and they're happy to take the premium,ÿ notes one banker with knowledge of the Pimco trades.

Asset swaps on government inflation-linked bonds have been a major source of supply of zero-coupon 0% floors over the past
year. Due to anomalies in pricing since the end of 2009, there has been huge demand to buy government linkers and asset-swap
out the inflation component - a trade that leaves the dealer holding the zero-coupon 0% floors embedded in the bond (


November 2009, pages 58-60; May 2010, pages 50-52).

This supply has meant a lot of the hedging activity this year has been in zero-coupon options. Year-on-year options were
previously more popular, with much of the demand for 0% floors coming via the structured note market. However, a lack of
supply meant dealers were left warehousing short year-on-year floor positions, which burned them badly when inflation
expectations dropped sharply at the end of 2008 (see box).

Dealers say the amount of year-on-year options trading in 2010 has been similar to 2009, but zero-coupon option volumes have
increased by about three times. ÿ
ero-coupon options trade in clips of several hundred million most days now, whereas before
they rarely traded in the interdealer market. That's not to say they didn't trade - it was a two-way market in the past, but it didn't
really have the same degree of significance,ÿ explains Paul Canty, London-based head of European inflation trading at Deutsche
Bank.

The market has received a further boost since the Fairfax and Pimco trades. The two transactions were widely reported in the US
press, and dealers say they have seen a stream of enquiries from investors since then. ÿSince news of the large trades came o ut,
we've seen many accounts coming in to ask what they can do in inflation,ÿ says Carl Bonde, inflation volatility trader at Citi in
New York.

In particular, Pimco's decision to take advantage of high prices and sell zero-coupon 0% floors has caught the attention of other
real-money and hedge fund clients, dealers say.

According to Kari Hallgrimsson, London-based European head of inflation trading at JP Morgan, a growing number of investors
are willing to sell inflation floors, believing prices to be too high. ÿ hen the floors were trading at a high in the US and Europe, it
struck a lot of hedge funds, prop desks and banks that the market was pricing in the likelihood of a Japan -like scenario too
aggressively,ÿ he observes.

Sophisticated investors have taken advantage of these prices in a variety of ways. Dealers report a pick-up in hedge fund activity
over the course of the year, with some going short inflation volatility by selling straddles and strangles. Both strategies i nvolve
selling puts and calls, allowing traders to benefit if high levels of implied volatility aren't realised. ÿ e saw some he dge funds
coming in and selling inflation volatility in the shorter tenors. They sold straddles or strangles so they don't have any ris k to the
delta of the move in the actual inflation rate - it's just a pure short volatility position,ÿ says Citi's Bonde.
Opportunities have existed on both sides of the Atlantic. At the beginning of the year, 10 -year zero-coupon 0% floors on European
HICP inflation were pricing around 59bp lower than 10-year zero-coupon 0% floors on US CPI, according to Bloomberg.
However, zero-coupon 0% floors on US CPI have been trading lower than those on the HICP since October 4. The move has
reaped profits for some hedge funds that had gone short 0% floors in the US and long 0% floors in Europe, says Bonde. On
October 13, 10-year zero-coupon 0% floors on US CPI continued to trade 14bp below floors on the HICP.

Meanwhile, most of the demand for inflation floors from pension funds and insurance companies has centred on the 10-year point
- creating opportunities for some who are willing to play 10-year options against other tenors. ÿThe 10-year zero-coupon 0% floor
is the most expensive point on the curve because that's what many clients have chosen to buy and they prefer this over anything
else. That means there's relative value to be had between being short that and long other strikes,ÿ explains Canty at Deutsche
Bank.

Activity hasn't been constrained to 0% floors, though. Uncertainty about the future path of inflation has led to high risk pr emiums
on inflation volatility when compared with nominal interest rates, say dealers. In the past, nominal rate volatility has tended to
trade higher than inflation volatility. The opposite occurred during the first quarter of 2010 - catching the attention of sophisticated
corporate hedgers that are already active users of interest rate products.

ÿThe attention of corporates has been drawn to the fact that inflation volatility is out of sync with nominal rate volatility . They're
quite comfortable with vanilla Euribor options and caps and floors, so it's quite natural for them to start asking about inflation
options, given how rich they are compared with Euribor options,ÿ says Mark Greenwood, London -based head of inflation options
at Royal Bank of Scotland.

An obvious way to take advantage is to sell five-year 5% inflation caps and buy five-year 5% Euribor caps, pocketing the
difference in premium between the two, he says. The risk to the client is of inflation outpacing interest rates - a scenario
Greenwood believes is unlikely. ÿThe European Central Bank has generally automatically responded to high inflation expectations
by hiking rates. It's hard to imagine sustained negative real rates,ÿ he explains. For corporates with liabilities linked to Euribor that
are already long inflation - a real estate company receiving inflation-linked rents, for example - this kind of trade can be attractive,
say dealers. Although the strategy entails giving up the potential upside from increases in inflation above the level of the cap, it
also reduces the risk presented by a spike in interest rates.

Clients have also looked to profit from high inflation volatility by selling inflation floors against interest rate floors, s ays
Greenwood. This is a trickier bet though, as interest rates are unlikely to be set below zero - meaning investors have to think
carefully about the level at which to buy the interest rate floor. Overall, the market has seen ÿsubstantial tradingÿ in Euri bor caps
versus inflation caps and Euribor floors versus inflation floors, adds Greenwood.

For the most part, however, clients have been looking to express more fundamental views, encouraged by the Fairfax and Pimco
trades. This bodes well for the market, says Chriqui at Barclays Capital. ÿIt's quite positive you have two large end -users deciding
inflation volatility is a useful asset class for hedging their holdings. At the moment, dealers have difficulty warehousing large -
sized positions, but if you have end-users with opposing views, it has the potential for increasing liquidity dramatically. That's part
of the reason we saw an increase in activity in zero -coupon options this year,ÿ he says.

Bankers also say they are receiving calls from a broader range of clients - and even central banks. In contrast to earlier fears about
deflation, a number of these participants are growing increasingly wary about inflation. In recent weeks, expectations of a return
to quantitative easing by the Federal Reserve have caused the price of 10-year zero-coupon 0% floors on US CPI to fall from
159bp on September 2 to 97bp on October 13, according to Bloomberg. Similarly, 10-year zero-coupon 0% floors on European
HICP fell from a peak of 133bp on August 26 to 111bp on October 13.

Anxiety over the impact of any new round of quantitative easing has also provoked a recent uptick in demand for high-strike caps,
says Citi's Bonde. ÿThe focus has changed from floors to caps. Low-strike volatility has cheapened and high-strike volatility has
become more expensive, so there's been a change in terms of those extreme strikes,ÿ he says.

&

Floors cleared, say dealers

The popularity of inflation-linked notes with embedded year-on-year 0% floors in the years leading up to the crisis left dealers
with significant short floor positions. The majority of banks had not attributed much value to t hese options, seeing the likelihood
of deflation as remote - an assumption that caused huge mark-to-market losses at the end of December 2008 as inflation
expectations dropped dramatically following the collapse of Lehman Brothers (

 January 2009, pages 68-70).

Despite seeing increased demand for 0% inflation floors over the past year, combined with a rise in implied volatility, deale rs
claim they have not faced the same problems on short positions this time around. For a start, inflation volatility has crept up from
a baseline that is already high, says Benoit Chriqui, head of European inflation trading at Barclays Capital in London. hat' s
more, the losses suffered in 2008 meant dealers wasted no time in hedging their short year -on-year inflation floor positions. ÿOnce
the recovery started showing signs of stalling, dealers were quick to cover their 0% floors, as the big vol move at the end o f 2008
was still very fresh in everyone's memories. I don't think the environment is as vulnerable as in 2008,ÿ he says.

Dealer books are less leveraged than in 2008, he adds. In addition, the appetite for inflation -linked structured products has slowed
down this year, to some extent curtailing the short floor positions dealers have built up. At least in part, this is due to t he
expensiveness of low-strike floors, which has made for less compelling payouts.

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