Inflation Swaptions

Dan Haehnel & Jonathan Levy

Inflation Trading Desk
CONFIDENTIAL
Inflation Trading Desk
Paris, 5 6 April 2011
Summary
1. Global Picture
Back to basics, Inflation Swaptions mechanism
Clients needs
Whats your flavour? Inflation and Real Rate Swaptions
2. Valuation and risk management
Available typology of pricing
Theoretical pricing in a pure swaption market
1
Theoretical pricing in a pure swaption market
Pricing with liquid instrument, maths versus flows
Risk management
3. Where do we stand, what is the next step?
No interbank market on swaptions today
Need a daily fixing
New liquidity for more exotic structure
Global Picture
Back to basics, Inflation Swaptions mechanism
Clients needs
Whats your flavour? Inflation and Real Rate Swaptions Whats your flavour? Inflation and Real Rate Swaptions
Back to basics, Inflation Swaptions mechanism
What is a swaption ?
A payer/receiver inflation swaption gives the right to enter into a payer/receiver inflation swap with tenor T
e
T
s
at
time T
s
at a pre-specified rate k. We denote this as a T
s
x (T
e
T
s
) inflation swaption. The mechanics of an inflation
swaption are given in the following figure :
At initiation
Upfront premium
Swaption
buyer
Swaption
seller
3
At maturity (physical settlement)
Enter into the inflation swap at agreed rate if
Inflation swap has positive value for buyer
Example :
The buyer of a receiver swaption, buys the right, against a fee payment, to enter at a future date previously
fixed, into an inflation receiver swap. The swap rate fixed is called the swaption strike. The tenor and the
notional are fixed at the trade date of the swaption.
Swaption
buyer
Swaption
seller
Back to basics, inflation Swaptions mechanism
Settlement conventions
Two types of conventions for swaptions:
Swap settlement : At maturity date, we enter or not into the swap
Cash settlement : At maturity, we receive or we pay a PV that equals the mark-
to-market
4
Choice between Swap and Cash is made at the trade date
Market is naturally Swap settlement
Back to basics, inflation Swaptions mechanism
Some observations
The price of payer swaption decreases while it increases for a receiver one when the strike
increases. We retrieve the fact that an out of the money swaption is less expensive than in the
money.
The price of a swaption (P or R) increases with the maturity of the underlying, as the volume of the
flows increase with maturity. This is so called multiplicative effect of the sensitivity.
The underlying of a swaption is the forward swap matching the terms of the swaption. For example,
a 5y x 5y 3% R swaption is based on the following forward
5
We then observe the usual Payer/Receiver parity as on options:
Clients needs
Buyers and Sellers
Buyer side is the most natural way
Forward hedge can be done with a swaption
Project finance,
Execution is linked to several factors
Swaption allows its owner to hedge against the movements of the inflation swap market
6
Retail clients,
Uncertainty on the total amount of the note that will be raised
Price of the futures issues can be locked at current market levels
Relative value and the seller : a new story
Buyers used to sell another strike swaption in order to have zero cost position
Generally this strategy is a collar swaption
Whats your flavour? Inflation Swaption
Wide range of products
Inflation Year
on Year
Swaption
Inflation Zero
Coupon
Swaption
Real Rate
Year on Year
Swaption
Inflation Swaptions
7
Swaption
Inflation
Index
Swaption
Real Rate
Linker
Swaption
Swaption
Real Rate Swaptions
Whats your flavour? Inflation Swaption
Inflation year-on-year swaption
This swaption gives the right to its owner to enter into a year on year inflation swap
+k +k +k +k +k +k +k +k +k +k
Swap/Cash
Settlement
8
I
17 -1
I
16
I
18 -1
I
17
I
19 -1
I
18
I
20 -1
I
19
I
21 -1
I
20
I
22 -1
I
21
I
23 -1
I
22
I
24 -1
I
23
I
25 -1
I
24
I
26 -1
I
25
0 5 y 15 y
Whats your flavour? Inflation Swaption
Inflation year-on-year swaption
Term sheet
Notional: 100,000,000
Index: HICPxT (non revised)
Source: First publication by Eurostat as shown on Bloomberg CPTFEMU
Start date: 1 May 2011
Option end date: 1 May 2016
Swap end date: 1 May 2026
Type: Year-on-year
Reference month: February
9
Reference month: February
First fixing: not yet known.
Buyer: The right to enter into a fixed payer inflation swap starting 1 May
2016 and ending 1 May 2026 with annual flows
k HICPxT (Feb/16 + i) , where r denotes the inflation swap rate at
HICPxT (Feb/15 + i - 1)
1 May 2016 for the February 2016 to February 2026 inflation swap.
Seller: upfront premium
Whats your flavour? Inflation Swaption
Inflation year-on-year swaption pros and cons
- +
10
Whats your flavour? Inflation Swaption
Inflation zero coupon swaption
Swap/Cash
Settlement
(1+k)
10
-1
This swaption gives the right to its owner to enter into a zero coupon inflation swap
11
I
26 -1
I
16
0 5 y 15 y
Whats your flavour? Inflation Swaption
Inflation zero coupon swaption
Notional: 100,000,000
Index: HICPxT (non revised)
Source: First publication by Eurostat as shown on Bloomberg CPTFEMU
Start date: 1 May 2011
Option end date: 1 May 2016
Swap end date: 1 May 2026
Type: Zero-coupon
Reference month: February
Term sheet
12
Reference month: February
First fixing: not yet known.
Buyer: The right to enter into a fixed payer inflation swap starting 1 May
2016 and ending 1 May 2026 with annual flows
(1+k)
10
HICPxT (Feb/26) , where r denotes the inflation swap rate at
HICPxT (Feb/16)
1 May 2016 for the February 2016 to February 2026 inflation swap.
Seller: upfront premium
Whats your flavour? Inflation Swaption
Inflation zero coupon swaption pros and cons
- +
13
Difficulty to assess
the forward swap as
forward start swaps
are not liquid
Option on the
standard swap that
quotes in the market
Whats your flavour? Inflation Swaption
Inflation Index zero coupon swaption
(1+k)
15
-1
Swap/Cash
Settlement
This swaption gives the right to its owner to enter into a zero coupon inflation swap, but now it is not
a forward start swap, because the start date of the swap is in the past
14
I
26 -1
I
11
0 5 y 15 y
Whats your flavour? Inflation Swaption
Inflation Index zero coupon swaption pros and cons
- +
15
Whats your flavour? Real Rate Swaption
Real Rate year-on-year swaption
+EIB
6m
+EIB
6m
+EIB
6m
+EIB
6m
+EIB
6m
+EIB
6m
+EIB
6m
+EIB
6m
+EIB
6m
+EIB
6m
Swap/Cash
Settlement
This swaption gives the right to its owner to enter into a Real Rate year-on-year swap
+EIB
6m
+EIB
6m
+EIB
6m
+EIB
6m
+EIB
6m
+EIB
6m
+EIB
6m
+EIB
6m
+EIB
6m
+EIB
6m
16
0
I
17 -1
I
16
I
18 -1
I
17
I
19 -1
I
18
I
20 -1
I
19
I
21 -1
I
20
I
22 -1
I
21
I
23 -1
I
22
I
24 -1
I
23
I
25 -1
I
24
I
26 -1
I
25
15 y
+k +k +k +k +k +k +k +k +k +k
Whats your flavour? Real Rate Swaption
Real Rate year-on-year swaption
Notional: 100,000,000
Index: HICPxT (non revised)
Source: First publication by Eurostat as shown on Bloomberg CPTFEMU
Start date: 1 May 2011
Option end date: 1 May 2016
Swap end date: 1 May 2026
Type: Real rate
Reference month: February
17
Reference month: February
First fixing: not yet known.
Buyer: The right to enter into a fixed payer inflation swap starting 1 May
2016 and ending 1 May 2026 with annual flows
Euribor 6m HICPxT (Feb/16 + i) , where r denotes the inflation
HICPxT (Feb/15 + i - 1)
real swap rate at 1 May 2016 for the February 2016 to February 2026
inflation swap.
Seller: upfront premium
Whats your flavour? Real Rate Swaption
Real Rate year-on-year swaption
- +
18
Whats your flavour? Real Rate Swaption
Real rate OATi format swaption
+EIB
6m
+EIB
6m
+EIB
6m
+EIB
6m
+EIB
6m
+EIB
6m
+EIB
6m
+EIB
6m
+EIB
6m
+EIB
6m
Swap/Cash
Settlement
This swaption gives the right to its owner to enter into a Real Rate OATi like swap
+EIB
6m
+EIB
6m
+EIB
6m
+EIB
6m
+EIB
6m
+EIB
6m
+EIB
6m
+EIB
6m
+EIB
6m
+EIB
6m
19
0
k * I
26
I
11
5 y 15 y
k * I
25
I
11
k * I
24
I
11
k * I
23
I
11
k * I
22
I
11
k * I
21
I
11
k * I
20
I
11
k * I
19
I
11
k * I
18
I
11
k * I
17
I
11
I
26 -1
I
11
Whats your flavour? Real Rate Swaption
Real rate OATi format swaption
- +
20
Valuation and risk management
Available typology of pricing
Theoretical pricing in a pure swaption market
Pricing with liquid instrument, maths versus flow Pricing with liquid instrument, maths versus flow
Risk management
Available typology of pricing
The possible market evolution
Characteristics
Expiries from 1M to 30y
Flavoured tenors: 1y to 5y , 10y, 30y
Quotes cents ( Be careful of CSA issue in non-synchron flows : ZC, Currency CSA must
be taken into account too)
22
Swaptions market is not liquid
Recovering the liquidity of natural instruments (Caps/Floors on inflation)
Nevertheless, necessity of challenging the projection with a pure swaption vision
Then Cap & Floor vol projection vs Swaption vol basis evolve with the natural flows (Wedge
history on IRD)
Theoretical pricing in a pure swaption market
Basics for swaption pricing
It is crucial to consider swaption as a pure instrument
This approach will avoid any misleading
Pure swaption approach can be done in 3 differents frameworks
Normal Filter for the Swap rate dynamic
23
Normal Filter for the Swap rate dynamic
Lognormal Filter for the Swap rate
Stochastic Volatility for the Swap rate
Theoretical pricing in a pure swaption market
The Normal Filter
The swap rate is assumed to follow
The price of the swaption is :
24
The swap rate is assumed to follow
The price of the swaption is :
Theoretical pricing in a pure swaption market
The Black Filter
25
For ATM we have :
The swap rate is assumed to follow
The price of the swaption is :
Theoretical pricing in a pure swaption market
The SABR Filter
26
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( ) ( )
( )
( )
( )
( )
( )
( )

+ +
=
|

\
|

(
(

+

+

+
(

\
|
+ |

\
|
+

=

1
z z z 2 1
ln : z x
and
K
F
ln
2
1
FK
v
: z
where
T
24
3 2
v
FK 4
v
FK 24
1
1
z x
z
K
F
ln
1920
1
K
F
ln
24
1
1
2
1
FK
F , K
2
x
2
2
2
1 1
2 2
4
4
2
2
imp
Pricing with liquid instruments, maths vs flows
Our Pricing Philosophy for Exotics
For benchmarking exotics, the more intuitive approach is to look at a model that has an intuitive
hedge with a vanilla plain basic:
Price of a derivative is the price of its hedge
We must uncharge models from explaining a product, thinking price means thinking hedge, so costs
27
We are looking for models that have the ability to measure properly exotic risks, leaving boundable
and measurable exotics residual risks.
YoY Swap rate is seen as a basket on YoY
Projection is done on Cap/Floor smile + Correlation risk
The smiling process is based on an intuitive replication argument
Pricing with liquid instruments, maths vs flows
Our Pricing Philosophy for Exotics
Components of this framework :
1. Yoy smile available by smiling methodology
2. Convexified Law Convexity on each Yoy (Sensi Vol ATM Euribor + Yoy + Correlation)
3. Autocorrelation structure Flexible structure is needed
4. Pricing & hedging procedure are then mixed up.
28
Zc options
Yoy
options
Discount
effects
Pricing with liquid instruments, maths vs flows
Pricing of Inflation year-on-year swaption
Inflation
Correlation
structure
29
Inflation Year on Year
Swaption
options
Yoy
options
Rates
swaptions
Pricing with liquid instruments, maths vs flows
Pricing of Real Rate year-on-year swaption
Rate and Inflation
Correlation
Inflation
Correlation
structure
Discount
effects
30
Real Rate Year on Year
Swaption
ZC
options
Pricing with liquid instruments, maths vs flows
Wedge is a correlation trade/exposure
Wedge is a correlation trade/exposure: Cap/floor straddle vol vs corresponding swaption vol (2x4
vs 2y2y , 5x10 vs 5y5y)
A proxy for the implied correlation of short forward rates
Cap = portfolio of caplets, ie portfolio of options on short forward rates: The change in short
rates correlation has no impact on the price of a cap
Swaption = an option on a portfolio of short forward rates: correlation of short forward rates
31
Swaption = an option on a portfolio of short forward rates: correlation of short forward rates
matters
An increase in correlation will increase the swaption vol with respect to cap/floor vol and vice
versa
Wedges are very sensitive to market flows as it can be describe as a pure relative value trade
Pricing with liquid instruments, maths vs flows
Analogy to the yoy and zero coupon option market
Inflation volatility market started with year on year options
Flows were only on structured products (yoy format)
Players were implying zero coupon volatility thanks to models
In 2007 embedded floors on linkers asset swaps started to be quoted
Dynamic on both markets was really similar especially during 2008 crisis
With massive buying flows on zero coupon options in 2010 (Insurance company on 10y 0% floor
32
With massive buying flows on zero coupon options in 2010 (Insurance company on 10y 0% floor
zc), joint dynamic is changing
Then a proper market on each kind of option is emerging
But it is always important to keep in mind the implied correlation parameters between the two
markets
Pricing with liquid instruments, maths vs flows
Analogy to the yoy and zero coupon option market
33
Pricing with liquid instruments, maths vs flows
Analogy to the yoy and zero coupon option market
34
Pricing with liquid instruments, maths vs flows
Analogy to the yoy and zero coupon option market
Then for swaptions, this representation is just useful for a start point to develop the market
It is important to not be stuck with this representation as the flows on the underlying could generate
a basis between the Cap/Floor smile and pure swaption smile
As conclusion Maths could stay behind flows, the rule is done by offer and demand in illiquid
market.
35
Year on
Year
options
Zero
coupon
options
Inflation
Swaptions
Risk Management
Toolbox for Risk management
For a chosen model greeks are given
Delta
Strike influence :Delta in absolute value is increasing is this sens : OTM ITM
Line Delta (tenor) Line Delta is moving proportionally to the sensi of the swap (Line delta, with respect to the
underlying maturity)
Column Delta same than standard underlying as equity
Vega
Vol is stored in a cube ( Maturity, Tenor , Strike)
36
Vol is stored in a cube ( Maturity, Tenor , Strike)
Vega is an increasing function of the vol
Strike influence : Maximal ATM of the underlying
Line Vega is moving proportionally to the sensi of the swap
Colum Vega as a belly shape with the maturity (sensi effect, the variance is not compensated by the discounting
effect of the Zero-coupon, so for a given maturity vega is decreasing)
Gamma
Strike influence : Maximal ATM as classical results
Line Gamma is moving proportionally to the sensi of the swap
Column Gamma same than standard underlying : decreasing with maturity
Where do we stand, what is the next step?
No interbank market on swaptions today
Need a daily fixing
New liquidity for more exotic structure New liquidity for more exotic structure
No interbank market on swaptions today
Brokers are developing platform for quoting swaptions
Players have to quote it on an interbank base in order to generate a market
The transparency of this market is the key word for a good development
38
Need a daily fixing
Proposed format
Which contributors: Banks are selected by ISDAFIX for interest rate swaps (IRS)
Prices quoted: where each dealer would quote the mid-market inflation swaps
Rates reported are made public
Year-on-year versus zero-coupon rate
Year-on-year inflation swaps could easily be combined with IRS rates, but they are less liquid than
zero-coupons
39
Interpolated versus monthly inflation indices
Different market conventions: French and US inflation swaps trade on an interpolated basis while
euro zone and UK trade on a monthly fixing
Real versus inflation rate
Real rates can be computed directly from the IRS and zero-coupon inflation swap fixing
What maturities should be contributed
Specified by each panel contributors based on which maturities are relevant to their market
Need a daily fixing
Trading platform can provide daily mid market level
40
Need a daily fixing
Short-term benefits
Attract more participants to the inflation derivatives market
Increase volumes and liquidity of zero-coupon inflation swaps
More comfort for investors holding inflation derivatives
Use of the fixing for swap terminations and cash-settled options
Best execution to clients thanks to benchmarking the price of inflation derivative transactions
41
Long-term benefits
Proper setting for exotic products
Increase client demand for exotic products
5/10 year fixing could be used as the underlying benchmark for new cash-settled futures contracts
More exposure to inflation expectations for users in long-term inflation futures contracts and
tighter bid/ask spreads
New liquidity for more exotic structure
Pricing callability easily
Offering flexibility on zero coupon swaps
Creation of a new range of products: CMS on inflation
42
Creation of a new range of products: CMS on inflation