Onwards and upwards

Options

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As a product, inflation options have been around for a good five years. Until this year, however, there was nothing resembling a market. Inflation options were traded infrequently, typically in small sizes between a dealer and a client, and the exposure that banks took on often remained unhedged. The arrival this year of a new breed of structured note - inflation range accruals - has changed all that.

Range accrual notes - an established structure in the interest rate market but new to inflation - allow investors to bet that the European Central Bank (ECB) will be successful in keeping eurozone inflation close to its publicly stated target of 2%. Offering this kind of payout means banks are long volatility - they are exposed if inflation remains stable - so they have looked to offset the risk by selling caps and floors to other dealers.

The resulting interdealer options market remains illiquid, but activity has picked up considerably. Twelve months ago, one inflation cap or floor might have traded each month, says Christian Alibert, co-head of inflation trading at Royal Bank of Scotland (RBS) in London. This year, there has been an average of four trades a week. Banks are now quoting prices on a daily basis, and the emergence of observable price points for caps and floor has given the market greater confidence to sell more complex structures - such as the range accrual notes themselves.

"It's been a bit of a chicken and egg situation," says Dariush Mirfendereski, head of inflation-linked trading at UBS in London. "To facilitate the structured note business, we needed a degree of activity to develop in caps and floors, so there was information about where people were pricing skew and smile at various strikes. But people needed a reason to start trading caps and floors."

Earlier this year, the first range accruals provided that reason. Unlike other, more plain vanilla inflation-linked structured notes, range accruals are hard to price and are too risky to be left unhedged.

"Range accruals are essentially like two digital options. It's not a bet on direction, it's a bet that inflation will not significantly deviate from current expected levels, and as such will be more sensitive to volatility than to outright levels of inflation," says Benoit Chriqui, head of European inflation trading at Barclays Capital in London. "Since digitals can be viewed as highly leveraged cap-spreads or floor-spreads, they will tend to have significantly more vega than normal, unleveraged caps and floors, particularly at inception when you are far from the boundaries."

To price the notes correctly, banks needed not just one or two pricing points from the options market but a more comprehensive picture. Range accruals have helped provide that. Some investors have taken a relatively conservative stance on the ECB's ability to target inflation, opting for ranges with some room for inflation to overshoot or undershoot the target - for instance, 0-3%. Others have been emboldened by the central bank's recent record - realised inflation in the eurozone has been either 1.8% or 1.9% for the past nine months - and have taken more risk, in some cases buying notes with a range as narrow as 80bp, says Alexandre Zeidenberg, exotic inflation trader at Societe Generale Corporate and Investment Banking (SG CIB) in Paris.

Of course, the narrower the range, the greater the pick-up on offer. David Slater, London-based head of structured inflation trading at BNP Paribas, says a five-year structure can offer anything between 15bp and 125bp over Euribor, depending on how aggressive the investor wants to be.

The variation in ranges means dealers have to hedge by trading a variety of caps and floors, struck at different levels. "Investors decide how wide they want the range to be, so banks have to hedge using an assortment of options. We're seeing options that are at-the-money, very deeply in or very deeply out, and, as a result, we're building up a picture of skew and smile that took many years to develop in the interest rate market," says Alibert of RBS.

But it's still a long way from being a complete picture. Stephane Salas, head of inflation trading at SG CIB in Paris, says most of the range accruals tend to have a relatively narrow range - going out as far as 3%, but more typically ending at around 2.5%: "Most of the notes being done involve investors betting that the ECB will be able to maintain inflation around the 2% area, while selling options with strikes above that level to get an enhanced payout. If we put the strike on those options at 4%, they wouldn't get much value out of it."

As a result, understanding of inflation options pricing may not be as robust as some dealers like to claim. "This is not a liquid market," says the head of inflation trading at a large investment bank. "Many people have to mark-to-model to get these notes done, and there are still a lot of unanswered questions about the dynamics of inflation volatility that lead us to be cautious. We're not doing jumbo issues with institutional clients who are going to ask for very aggressive prices."

Instead, the investment bank has restricted itself to a large number of bite-size transactions totalling around EUR30 million-50 million, he says. Other dealers have been much more bullish, issuing jumbo notes worth as much as EUR100 million each, and the inflation trading head says at least one of these issuers ran into trouble on a trade. After printing the deal, the issuer had to push EUR100 million in out-of-the-money caps and floors through the market in a single day to hedge itself. But before it had a chance to do so, implied volatility in the options market fell around 3 percentage points, probably resulting in a net loss on the trade, he says.

"The issue was for a big investor, where you're not going to be able to add a 7-8% margin to cover the risks related to price and illiquidity. So when you see a drop of 3 percentage points before the bank has had a chance to hedge, you've got to assume that it made a loss."

UBS' Mirfendereski also sounds a note of caution: "The assumption is that vanilla options are now priced efficiently and everyone knows where the prices are. But trades are not very frequent, and what happens is that the few points that do trade are used to calibrate models to price other strikes and maturities.

"There is a danger that people are getting slightly ahead of themselves. Obviously, if you can charge a sufficient premium to compensate for the risk, then all well and good. But that might not always be possible."

No records

Despite the fire they have lit under the interdealer options market, range accruals aren't going to set any records for volume. Individual issues range in size between EUR3 million and EUR100 million. RBS has transacted around EUR300 million, says Alibert, who estimates that the market as a whole is worth up to EUR1 billion.

In years gone by, other inflation-linked notes have been more popular. The market's heyday was in 2003, when low interest rates and a struggling equity market prompted investors to search for other assets. That year, banks sold a total of around EUR12 billion in inflation-indexed notes, mostly paying out inflation plus a spread. To provide investors with a minimum guaranteed return, banks typically embedded a zero-inflation floor in the deal: if inflation was negative, the investor would not lose his or her principal.

Despite the huge volume of inflation-linked notes, banks generally opted not to hedge, says Mirfendereski: "It might sound cavalier, but the risk of deflation was not huge, and if the market was turning against you, there would still have been time to go out and buy some protection in the form of interest rate floors."

Dealers are not taking the same approach to range accruals. However, the successive waves of interdealer hedging sparked off by range accrual issuance have caused implied volatilities to drop sharply since the start of the year (see chart). In turn, the fall in volatility means new range accrual notes offer investors less pick-up on the options they're selling to the issuer.

"Banks were long volatility as a result of the range accruals so they needed to sell optionality in the interbank market - and because these were the only structures trading during this period, all banks were sellers and there were no natural buyers, which drove the options market lower," explains Vincent Voeten, global head of integrated inflation products at ABN Amro in London.

Volatility on a 10-year 0% floor dropped from 0.6% at the start of the year to 0.5% now, says Voeten: "In absolute terms, that's a move of only 0.1 percentage point but in relative terms it's almost a 20% drop in volatility."

With range accruals looking less attractive, what happens next? RBS's Alibert says the rapid growth in the market's sophistication means there is no natural next step: "In other markets, you've seen a gradual evolution with swaps coming along first and then caps and floors, then swaptions, then exotic options, structured notes and hybrids. In inflation, that's all been happening at once. So the next product might not be particularly complex - it might just be an application that we hadn't had the opportunity to offer before."

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