ECB has raised the amber flag with regards to fighting inflation arising due to persistent higher oil prices. US FED is on permanent hold with regards to hiking interest rates. This is creating a divergence in front end of the yield curve. On the long end, 10y and 30y rates are currently gaining traction from anticipation of end of QE2 world in June 2011.
In Interest rate derivative markets, Options on Yield curve Spread and also digitals are traded very often. To provide Yield curve pick up to investors, often issuers come up with structured notes paying coupons tied to the Yield curve spreads. The Embedded options in these structured notes needs to be hedged by the dealers in the market. The Yield curve spread options can be created as spread between 30y and 2y rates above 0. This means Yield curve will not invert. Another class of notes will pay a coupon if this spread is above zero. This product is classified as spread digital product. In this article I would like discuss some market facts about Spread options and spread digital options.
Spread products: Primary driver for spread products is to make a bet on the shape of the yield curve and underlying correlation structure. Yield curves take variety of shapes, including flat, steep, inverted, concave, convex etc based on where the interest rates are trading in spot and forward space. Interesting aspect of the spread products is they capture the forward yield curve in the structure. For instance a spread option that pays when spread between 30y and 2y is above 0 every quarter 5y from today to 10y from today is betting on the yield curve in 5y forward. The market price of this option has a view on correlation between 30y and 2y rates. In this case, if an investor takes a position in a CMS spread option straddle, his core view is not on change in the shape of yield curve but change in the correlation. This means, he will buy the option if the yield curve is highly correlated and hence lower cost to get this option and at the same time he expects the correlation to fall. In other words, investor will be looking at higher implied correlations and fading them as time passes. This scenario can happen when yield curve steepening and flattening is accompanied by rising of 30y and falling of 2y and vice versa.
Now, let us take a look at actual markets.
Spot 2y rates is trading at 0.88 and spot 30y trading at 4.266. Similarly, 5y forward 2y is at 4.78 and 5y forward 30y is at 4.95. This clearly indicates, spot spread is at 338 and forward spread is flat 20bps. Just take a step back and understand the economic backdrop. USD fed has set the fed funds rates at very low (0 to 0.25 bps) and 2y rates are pegged to this fact. 30y rates are driven by growth in economy and inflation. As of today there is high uncertainty around these factors due to Fed Qe2 policy, Fiscal tug of war between US polity and economic recovery. Therefore, correlations have been on the rise due to this crisis phenomena. This suggests the Spread trades should be very cheap. There is a graph below that shows historical realized correlation between 5y forward 2y and 30y rates. I see current correlation is at 70%. But when I look at spread option market for quotes, I see market is very rich and it thinks implied correlations are very low. One answer to this is due to demand and supply in the market. That is there is huge bid for the CMS spread options and this is driving up the prices.
Now as I mentioned above CMS spread digitals are another class of products coming into existence due to hedging Range accrual products and opportunistic trades. Digital products trade prices are affected by two sources, one being steepness of yield curve and second being the underlying skew structure. Digitals can be valued as call spread or put spread options. In the case of a floor struck at 0, we will be modeling a bear put spread. In this we are long 0 strike put and short lower strike put. If low strike skew is rich and curve is steep we will see cheap digitals. Here also another interesting fact pattern arises that is when market has sold enough of these digitals due to low price and it being never getting into money and people are able to collect hefty premiums. At these low levels, people interested in buying tail hedges emerge to bid up the prices. This fascinating fact pattern attracts make me think how market players signal their one person’s rational behavior as other persons irrational behavior.
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