US inflation options sponsored forum: Recovery and development

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The Panel
Prabhat Arora
, Vice President, Interest Rate Exotics Trading, Bank of America Merrill Lynch
Ofer Fuchs
, Inflation Trader, Citi
Allan Levin
, Head of Inflation, North America, Deutsche Bank
Mark Greenwood
, Head of Inflation Options, Royal Bank of Scotland
Antonio Giampaolo
, Executive Director, Fixed Income Rates Trading, UBS Investment Bank
D’Arcy Miell
, Global Head of Inflation Products, BGC Partners

Risk: What are the major characteristics of the market in inflation options in the US compared with other derivatives markets?

Allan Levin, Deutsche Bank: It has been very exciting to see the development of the options market over the past six months. It has rapidly changed from being an illiquid market with little trading to being actively traded, on par with the more developed markets in inflation swaps.

To provide a little background on the markets, there have been two types of inflation options that have been trading typically. The first is year-on-year (YoY) inflation options. These caps and floors generally pay the difference between a strike and annual inflation on a yearly basis. A simple example would be a five-year cap that paid the excess of the annual inflation rate over, say, 4% each year. YoY options are typically embedded in inflation-linked structured notes.

The second type that is common is cumulative inflation options, which we often called zero-coupon caps or floors. These typically pay out on maturity – let’s say at the end of five or 10 years – and are based on cumulative inflation from inception to maturity date. For example, a 10-year zero-strike zero coupon floor would pay the difference between the current consumer price index (CPI) and the CPI in 10 years’ time should prices be lower in 10 years’ time than they are now. Zero-strike options of this type are similar to the redemption options embedded into Treasury Inflation-Protected Securities (Tips). Accordingly, there is liquidity in this particular type of option with significant volumes traded over the past few months.

I’d say the market for inflation options historically has been less developed than that of nominal interest rate options. The reason for this is simply because it’s a newer market, with fewer dealers involved. But this is rapidly changing.

Risk: What can we say about the market in terms of its size and the amount of growth we have seen in recent years?

D’Arcy Miell, BGC Partners: The options market first started to trade in 2008, but activity was sporadic and liquidity was limited. Towards the second half of 2009, the market gained considerable momentum and the volumes of 2009 at least doubled those of 2008. The majority of trading was in the second half of 2009, in particular the last quarter. An awful lot of this was on a zero-coupon basis. In 2010, the activity has been more evenly spread between YoY options and zero-coupon options. Our data shows that more was done in the first quarter of 2010 than in the whole of 2009 and preceding years combined. The market still continues to grow. What’s nice to see is that more participants are coming into the market and, in turn, contributing to a larger pool of liquidity.

Antonio Giampaolo, UBS Investment Bank:
As we talk about the structure of the US inflation options market, we have discussed the supply versus non-supply feature of the YoY options relative to zero-coupon options. To be able to understand the specific dynamics of this market, though, we also need to digress briefly on the type of players that are active and especially absent from it. In the US market, for example, the main absent is the pensions industry, which is a determinant of huge flows in zero-coupon options on the buy side in the euro market and in the UK. This feature makes the US market cheaper on the zero coupon relative to what has been going on in the euro once we take into account the higher realised volatility of the underlying forward index.

Mark Greenwood, Royal Bank of Scotland:
In the global context, in the first quarter of 2010, there was about $8 billion of interbank options trades across the major markets of euro, US and UK inflation. An increasing proportion of that is US options. Liquidity is definitely at a high point, unlike in the delta markets – where we are sitting on less than 100% of the pre-Lehman volumes. Antonio is right in that interbank flow is good. It is a proxy to what is happening in broader client flows, but it is far more important to look at what the natural flows are in the market to understand how it is going to develop. And there I agree, we don’t yet have the same balance of pension interest on one side and commercial property lease, etc., supply on the other side that characterise the sterling and the euro options markets.

Allan Levin: Prior to the crisis, the market for inflation swaps was a much larger market than that for options. But we’ve seen a dramatic change in the relative status between the two over the past six months. Despite healthy growth in inflation swaps, the market for inflation options has grown even more rapidly to the point that volumes trading this year are not dissimilar to swaps.

Risk: Apart from pension funds (notable for their absence), who are the major participants in the US inflation options market?

Antonio Giampaolo: The usual driver of the demand in YoY optionality is the structured medium-term note (MTN) issuance, and that goes mainly to retail investors because the YoY coupon structure suits that market. There, the size of the US market in 2010 is a fraction of the euro market. A few numbers help put this statement into context. So far there has been about €1.5 billion ($2 billion) printed in structured MTN issuance in Europe. In 2010 to date, there has been about $400 million or maybe less in the US. Expectations about equity returns, low prints on YoY inflation in the US and credit spreads being contained all contribute to what are perceived to be unattractive spreads on these notes from the point of view of retail. This has been only one of the dynamics of the market.

The relative-value players are also coming back. They used to be a source of YoY volatility. Some funds that were actively selling YoY volatility are not in business any more. Getting more of them involved now will mean providing the security and evidence that liquidity has come back after a period of drought. The market is stabilising around a new equilibrium where participants know they can put on relative-value trades and then unwind them without too much of an expense.

To these kind of players, we need to add other investors that have not come to the market yet. I have in mind traditional equity fund managers (noting that equity hedge funds have been involved). Analysis shows these are exposed to extreme inflation events that negatively affect the returns of their equity portfolios. Educating this class of participants and giving them enough comfort that is necessary to bring them to the market will be our next challenge.

Ofer Fuchs, Citigroup: A big change we’ve seen in the past few months that contributed to the exponential increase in volume in this market is from insurance and utilities companies. These companies have understood they need to hedge inflation, and that inflation is going to be volatile. They realise there could be outliers in the outcome of inflation – either there is going to be deflation or high inflation. They need to protect their assets, so they either need to buy deflation puts or inflation calls. Another participant that we saw coming in the past few months has to do with zero-coupon floors that are actually embedded in asset swaps. Some real-money players who actually hold the Tips in their accounts by default own the floors. They just decide to unstaple the floor and enhance the yield by doing that. Those are the two major participants that we have been seeing in the past few months.

Allan Levin: From a market that, until a couple of years ago, was driven purely by retail structured notes issuance, we now have a far broader array of participants, the notable ones being hedge funds that are not only taking relative-value views but are also taking positions – for example, that inflation will be range-bound and thus selling options straddles. Also, real-money institutions – insurance companies and asset managers – are either macro-hedging or selling covered positions.

In the current market, there is far more of a perception that tail risk needs to be hedged given recent volatility, and many counterparties are hedging economic scenarios they are concerned about using inflation options. Furthermore, many institutions actually have other implicit or explicit inflation exposure. They may have sold products that have an implicit inflation floor in them and they need to buy the floor to manage their risk; or they may be utilities companies that have energy contracts linked to inflation or even property companies that have leases that have inflation caps embedded into the growth in rentals. We are certainly seeing a broader array of participants and that is what is leading to the growth of the market.

Ofer Fuchs: The ability of the Street to create new structures – for example, the collar that most of us have issued in the past few months – is actually the key driver for the development of the market. That is, by creating a better balance between supply and demand, which was missing before because there are more natural buyers of those out-of-the-money caps or out-of-the-money floors. That is the key element for the development of the market.

Prabhat Arora, Bank of America Merrill Lynch:
As far as zero-coupon floors go, dealer desks themselves became buyers of these options during late 2008 as implied volatility on YoY floors exploded. Dealers had been short YoY CPI floors due to inflation MTN hedging. The next best hedge available in the market for these positions was zero-coupon floors. This is one reason why the valuation of zero-coupon floors went through the roof in late 2008. Since then, these options have cheapened significantly in terms of implied volatility. But, in my opinion, they are still very expensive and this indicates genuine uncertainty on the part of dealers and investors about a Japan-like, prolonged deflationary scenario.

Allan Levin:
Initially, the zero coupons became liquid before the YoY floors. Participants were using zero-coupon floors to proxy hedge their YoY positions but, now that the YoY floors are becoming much more liquid, it has reduced the reliance on zero-coupon floors.

Ofer Fuchs: Before the crisis, the zero-coupon floor had zero value. The fact that floor no longer carries zero value makes it more attractive to trade because accounts are ready to take positions. They are ready because they are able to see a two-way market, as some insurance/real-estate funds still perceive it as a cheap option to hedge their long-term inflation exposure, while other, more speculative, accounts believe those options are too rich as its skew/volatility implies too high a deflation probability over the course of the next decade. Therefore, there is more balance in demand and supply because of recent price action.
   
Risk: Has there been more activity going on in the centre, or is it still constricted to the highs and the lows?

Prabhat Arora: Of late we have seen some at-the-money straddles in the market, but volumes are negligible. From the client side, a lot of the demand is for high-strike caps as protection against a high-inflation scenario. A variety of clients are now genuinely worried about the potential inflationary impact of the unprecedented monetary stimulus by the US Federal Reserve. The good news is that there is some supply of these high-strike caps now. A decent volume of retail notes have printed in which dealers are buying 5%–8% strike caps in lieu of selling low-strike floors. This has pushed down the valuations of these caps relative to floors. On the other hand, we still have a lot of demand for 0% and negative strike YoY floors from the retail side as well as zero-coupon floors from real-money clients. The skew of the volatility surface reflects this concentration of demand on extreme strikes. The implied volatility on five-year to 10-year zero-coupon floors is especially high, implying a very pronounced skew.

Mark Greenwood:
Because the world has become polarised between deflation and hyperinflation fears and, because we have never been faced with more inflation uncertainty, all of the activity is around the extreme strikes. This typically means zero or sub-zero and 4% and above. Touching on what Ofer said about the structured notes market – as this is a dominant force because of all the options embedded in these structured notes – it is interesting to see that, much like three years ago in the euro market, volatility has been subsiding. I like to to monitor 10-year YoY inflation volatility compared to Libor volatility, which has been as low as 65% of Libor volatility for US CPI. We’re now sitting at 135%, so volatility has doubled. Euro inflation volatility had also dropped to 65% of Libor volatility in early 2008 because of range accruals and the kind of collared structures that we’re now seeing in the US and spread options – particularly between rates and inflation. All of these generate long volatility positions for dealers and obviously that weighed on volatility. Hopefully, we will see the same kind of natural remedy in the market to these high-volatility levels as dealers fine-tune structured notes in order to generate volatility. The kind of collared structures that have had the most success lately really only pushed the problem from high strikes down to low strikes because dealers sell 0% floors versus buy 5% caps. So, it’s not really a panacea. Range accruals and spread options are a more natural way to generate long volatility positions for dealers.

Prabhat Arora:
Range accruals do give long volatility positions to dealers. Dealers are basically buying high-strike digital caps and low-strike digital floors via these structures. However, if you have followed the exotics market in rates, range accruals can become extremely tricky to hedge in certain scenarios. It is also not prudent to think of digital floors as a hedge for short linear floor positions. For a range accrual with, say, a 0% lower boundary, when inflation crosses the strike, dealers risk getting doubly short gamma. That’s one reason why we haven’t seen range accruals take off to a great extent. This is an area where better inflation models and risk management tools will aid the dealer community. Also, the linear option market has to become a bit more liquid before dealers get more comfortable with these kinds of exotic structures.

Risk: During the crisis, was it just the case that the market hadn’t anticipated the possibility of deflation or are there some broader lessons that need to be learnt?

Ofer Fuchs: The basic problem was that everyone was short volatility via the YoY deflation floor. Since everyone was a seller, volatility was obviously mispriced; additionally, the dealer community didn’t hedge this short position. It was as simple as that.

Prabhat Arora:
The strike distribution was very concentrated. Everyone had sold floors with the same strike distribution from zero to -3%. Also none of the structures were callable, which added to the problem.

Mark Greenwood:
All liquidity fell away in the linear market. So that one-year swaps were gapping at 100 basis points in a day at one point, and consequently re-hedging the delta – gamma trading – didn’t succeed. It only pushed the market further against dealers – the so-called negative gamma trap.

Antonio Giampaolo:
Two main lessons that the financial community got out of the recent crisis are that no out-of-the-money strikes are too out-of-the-money for us not to bother with, and that inflation actually has some features that are remarkably similar to those of the credit market. When conditions deteriorate in the credit market, prices jump. The market doesn’t trade in a smooth and continuous manner, it gaps and it jumps. The gaps are wide and it’s very difficult to re-hedge your portfolio. Embedding these considerations into our models and pricing has been the challenge of the last years.

In the early stages of the inflation market, whenever we were first asked to write very out-of-the-money options for MTN investors (like 0% or negative strike YoY inflation floors), we could afford to look at the nominal rates market as a proxy hedge. In the euro market, when you wrote a 0% floor or a negative strike floor, you could buy 1½ times or even twice the notional of 2% nominal rate floor: what was then considered a very low nominal rate. As the market developed towards more liquidity and with more competition among players, that was not possible any more: competition brought prices down to unrealistic levels. So we went from an initial stage where everyone was selling at multiples of nominal rate volatility, down to 60% or 65% of nominal rate volatility. Now we are back to above 100%. At these levels, these trades again make sense and that’s where we will probably settle because, until there is a true seller of YoY volatility, the Street will be able to absorb and manage, in aggregate, only so much naked volatility risk without looking at proxy hedges in the nominal rates space.

Allan Levin:
The crisis was an excellent learning opportunity. When the inflation market was very stable and had low volatility, many of the risks were not necessarily apparent. However, at the time of the crisis, many of the secondary and tertiary risks became very significant. Having been through this experience, we’re now in a much better position to understand the risks of the products that we deal with, especially in options. We have improved our risk management systems and refined the way we hedge our risks. The market is now in a much better position to develop than it has ever been, as we understand the risks better, we understand what can go wrong and what can go right. That places us in a better position to manage crisis situations going forward.

Risk: I’m assuming that we’re talking about being less aggressive when pricing the floors into structured products, for example. But is there anything else that is tangible in risk management and modelling that you are working on?

Allan Levin: I’d say our risk management systems and our modelling were much simpler prior to the crisis because there wasn’t much to calibrate to. Generally, everything was priced off constant volatilities and correlations. I can certainly say, from Deutsche Bank’s perspective, we’ve spent a lot of time developing our models, making sure that we can appropriately calibrate our models to where the market is trading. Instead of having one flat volatility constant, we may have a surface of volatility taking pricing skews into account appropriately. This should be the case for many other banks as well. Our experiences have taught us to be much more sophisticated in modelling underlying markets.

The other thing we’ve changed is that the appetite to just warehouse risk is not the same as it was before. Although we certainly were hedging our exposures before, we are now much more diligent in hedging not just the primary risk but the secondary risks, and being much more careful that our hedges are closer to the exposures that we have. In general, risk management right now is much more robust and, if we run into problems in the future, we should be in a much better position to handle them.

Risk: Do we still see large short YoY positions in the market or has that largely been cleared out?

Ofer Fuchs: In general, that position is definitely not as big as it was before. Some of the risk just disappeared because it rolled off. Some of the risk didn’t disappear, it was just transferred. Dealers transferred the risks to relative-value accounts that decided, at this price of volatility, they could actually step in and sell volatility. Some dealers are simply more comfortable to short risk at this level, but it’s definitely less than what we saw before the crisis.

Mark Greenwood:
We alluded to this earlier, this idea of using zero-coupon 0% strike floors as generated from asset swaps on Tips as a broad proxy hedge for the YoYs. There is definitely much more sophistication now in understanding how you can, up to a point, replicate a YoY pay-off with a series of zero coupons. Zero coupons, after all, are the only floors where there is a natural supply. The Street will always be short YoY 0% floors as a result of these structured notes, even if they are rolling off. Joining up the YoYs and the zero coupons via the asset swap market has been an important development and enabled dealers to be prepared to sell more YoY floors than they would otherwise have been able to.

Prabhat Arora:
There is still a significant position in short YoY options on the Street. Like Ofer said, the old structures are rolling down in maturity, and the overall short volatility exposure of the Street has gone down. In addition, the inflation curve has normalised and, because of an upward-sloping curve, these options are so out-of-the-money that they are not a gamma-hedging headache any more. That has made dealers much more comfortable in risk managing these short positions for the moment. On the flip side, we have seen a pick-up in new issuance of structured notes, which have added to the same strike shorts. Dealers have mitigated this to a certain extent via collars, but it does not solve the issue of short position strikes being very concentrated. Overall I feel that, if we go back again to a scenario like 2008, we will still see some panic, although it wont be as bad as last time. The only two things that can really clear the overhang are supply of inflation volatility from relative value or other investors and innovation by dealers to generate supply.

Risk: Is hedge fund activity coming back into the market or are we still seeing relative-value funds playing in that space?

Mark Greenwood: No-one is pretending that the trajectory at which we saw hedge fund involvement two years ago in the dollar inflation or the broader inflation market has continued. The credit crisis caused many leveraged funds to unwind their inflation options positions. They are very sensitive to liquidity and inflation options are illiquid. However, there are encouraging signs. For a start, many of the leveraged funds that get involved in the inflation options market are not necessarily fixed-income specialists, they are sometimes credit or equity funds looking for a macro hedge against broader inflation scenarios. That’s an encouraging development that we didn’t see two years ago. The fixed income specialists have returned but they are looking at no longer than one- or two-year horizons because liquidity is so important to them, whereas in the past, they would have been happy to look at five-year horizons. It’s up to dealers to continue to do what we can to promote the market, to get the market more comfortable with the liquidity of these instruments. We have survived the extremely distressed markets of the past two years, still maintaining liquidity for clients. This should give end-users comfort that the options market is here to stay.

Ofer Fuchs: At the beginning of the year, and the end of last year, relative-value accounts were more focused on the one-year and two-year tenors, but what has been happening over the past few months is that after a lot of the opportunity was exploited, not just in the front end of inflation volatility surface but also in other asset classes, they are looking to exploit other opportunities that still exist in the inflation volatility market and that is in longer maturities. As result, some relative-value trades take an outright view on longer maturities, whether it’s five or seven years. Other relative-value trades focus on similar tenors but in cross-currency space or cross-product between rates and inflation trades.

Allan Levin: The market has changed significantly. A year ago, markets were unstable with very large moves. It was difficult to have a clear idea of how the market was going to develop. Markets have now stabilised both generally and in inflation. Risk appetites have increased because people are much more comfortable with where the markets are and how they will develop, whether it’s dealers or relative-value players or other participants. There’s no doubt that, just like the banks did when we reduced our risk appetite last year, hedge funds did the same. Our appetite has increased somewhat and that of hedge funds has as well. There are currently dislocations in inflation option market – much like there was last year in the Tips asset swap market. Accordingly, many funds are increasingly taking both relative-value and outright views. What’s even more positive is that there are many new participants entering the market. A couple of years ago, inflation was a niche product. More recently, inflation has been much more volatile and it likely to continue to be so for a few years at least. As a result, inflation is becoming much more of a mainstream market.

Risk: Are inflation options an easier sell in such an environment where people are more willing to take risks but, at the same time, there is uncertainty over the future rate of inflation?

Allan Levin: There is no doubt that the divergence of views on the future of inflation levels is driving much of the renewed interest in the market. There is clear disagreement among economists about the future path of inflation. In the US, we have seen this disagreement rise substantially since the start of the recession. It continues to do so. According to recent surveys, the probability of long-term inflation at low levels has increased, while the probability of elevated inflation has remained high and even edged up further despite inflation being at relatively low levels. There has also been an increasing trend by investors to hedge tail risk, which, given renewed volatility in inflation, has generated a significant amount of business. The fears of both deflation and hyperinflation are not going to go away anytime soon. That is going to continue to generate increasing interest as more and more players who weren’t involved in inflation continue to come into the business. These new participants have become comfortable with the market and they are not going to go away. We have had a fundamental change in the market and it has to become much more mainstream than it ever was before.

Mark Greenwood:
In the short term, inflation risk is as high as ever. Economists forecast the next print wrong by, on average, 25bp. This is as high as it was at the peak of the crisis when we saw US CPI prints drop from over +5% to -2% inflation – a 700bp range in just 18 months. Having lived through that range, many investors in the past who could have ignored inflation can no longer do so. That augurs well for the market because end-users can no longer afford to ignore the effect of inflation on their investments and balance sheets. Real money in particular will start to look at opportunities presented by the inflation options market.

Risk: Are you seeing an increase in interest from clients?

Antonio Giampaolo: We do see increased interest from clients. The biggest challenge that we have in converting that interest into actual trades is getting rid of the stigma that the market can actually dissipate or evaporate and liquidity can completely dry up. We can eliminate this impression over time and with more trading. If this can be done, there are going to be more players involved.

D’Arcy Miell: In the interbank market we are fielding more interest from banks on a daily basis and see an increased focus on options. It’s looking positive – if they are not in it now, they certainly have an intention to participate in the market at a point in the future.

Risk: Given the withdrawal of government support for banks and the gradual winding down of expansionary fiscal measures, can we expect to see this uncertainty over inflation continue?

Antonio Giampaolo: The uncertainty over inflation – which is proven by what is happening to the volatility of the swaps – is difficult to dismiss. We are witnessing a time when monetary and fiscal policy are at extreme levels both in the US and Europe. The return to normality via the reversal of these extreme measures is bound to bring on a divergence of views over what that means to several economic indicators, among them inflation. We are going to have two or three years of different views and hopefully that can translate into more trades to the extent that we can reassure investors that the market is more liquid and that liquidity is going to stay.

Risk: Does that encourage participation by macro-hedge funds and investors like that who have a broader view?

Prabhat Arora: Yes definitely. There are very mixed signals about inflation in the market right now. On the one hand, the Fed is still saying that inflation is not a concern, at least in the near term. If anything, the Fed is still more concerned about a potential deflationary spiral in the US similar to Japan. According to this school of thought, the high level of spare capacity in the US will be disinflationary. On the other hand, several macro funds have been proactive about buying protection against a high-inflation scenario. There was a huge demand from these investors for high-strike constant maturity swap (CMS) caps and inflation caps last year. So, clearly there are very divergent views in the market and this is generating demand for inflation options at both ends of the spectrum.

Ofer Fuchs:
The Fed has a dual role, which is to keep inflation on target and encourage growth in addition to that. That has actually contributed to the volatility in the market, and that volatility is going to make the US market even more attractive than the euro market.

Risk: The European inflation options market is more liquid and there is more trading along the curves there. Is there anything that the US can learn from Europe?

Mark Greenwood: There are definitely parallels between the euro and dollar markets, possibly more so than sterling where there’s very rigid indexation of pensions, and 0% floors and 5% caps are very prescriptive. In continental Europe, and in particular the Dutch market, there is conditional indexation, which means that pension funds that can’t afford full indexation will often sell caps to finance the indexation and the floors, which they generally do need. The US market is more akin to that. We’ve seen some very complicated structures relating to cost-of-living adjustments and so forth, which are not unlike what you sometimes see in the European market. But it will take a long time to see these hedged more precisely. These funds need to think about delta hedging first before they go worrying about the secondary, non-linear effects on their liabilities.

Risk: What can dealers do to encourage trade in the US inflation options market across the spectrum of market participants?

Ofer Fuchs: The main problem is that the market is still new to some of the participants, so accounts are not yet familiar with the technicals. Over time I expect this gap to narrow and accounts will feel more comfortable to trade this market. The other thing that we can do is create a better balance between supply and demand – for example, through the collar we all printed, which basically created the supply of high-strike caps. There is strong demand from insurance companies and other institutions that need to hedge inflation, so we as dealers can respond to this demand for low-strike floors and high-strike caps by structuring these range accruals and collars.

Prabhat Arora: Maybe, at some point, we will see a lot more callable inflation structures. That’s a big source of supply for the nominal rates market, the swaption market. If the same can happen in inflation, that will give dealers some much-needed optionality supply. Also, some of the things we talked about earlier – developing better models, better risk management tools to hedge exposures, and a growing willingness of the dealer community to again warehouse the risk at the right levels – will all make the market more balanced.

Risk: Is there always a risk in inflation that liquidity at times can dry up, or is that something that can be overcome with greater two-way participation?

Prabhat Arora: It can definitely be overcome and we have already seen it happen to a certain extent. For inflation options to become more liquid, it’s also important that the inflation swap market develops further and Tips themselves become more liquid. Also, the Street has re-priced the value of inflation optionality after the 2008 crisis and, at current levels, it again makes sense for dealers to sell inflation volatility. Current valuations also provide a great opportunity for relative-value investors to once again supply volatility to the Street. We will definitely see this happen in the near future, especially as other obvious trades in the market disappear. So I am sure we’ll have more two-way flow going forward

Risk: As the market gets more liquid, are we going to start to see more exotic structures in US inflation?

Allan Levin: It’s a natural evolution. As the market gets more liquid, as options become more available and more tradeable, it’s only natural that dealers will offer more innovative products.

Risk: Are you optimistic or pessimistic about the future of the market?

Ofer Fuchs: Volatility will stay, so yes, I am optimistic. Volatility means there will be growth in the market. I’m also optimistic about the growth of the market based on the flow from customers and the interest from new customers we’ve seen in the past year.

Mark Greenwood:
No discussion is complete without trying to imagine what the exotic market is going to look like in two years’ time and what other instruments might emerge. The next step of development is likely to be swaptions, be they on real rates or zero-coupon inflation. There are encouraging early signs in the euro market for both, probably more in zero-coupon inflation swaptions. In the sterling market, up until the time of the crisis, there was actually quite frequent client trade in real-rate swaptions, from insurers looking at buyouts of pension liabilities in a certain time frame, needing to hedge the real rate up until the buyout date, to pension funds doing collared structures selling covered real-rate payers to fund receivers. This is definitely an area where the market could develop to the benefit of everyone. It also addresses end-user concerns about liquidity for expiries up to, say, one or two years.

Allan Levin: We’ve seen structured notes issuance improve generally, not just for inflation. However, inflation-linked notes in the US are a far greater proportion of the market than ever before. Some of the larger trades in structured notes have been inflation-linked notes. I expect the stuctured note market will continue to grow. When it comes to more exotic structures, the structured note market often leads the way in the US. To some extent, US institutions and companies are more conservative than European institutions. But that’s not the case for retail investors in the US, who are much more comfortable in taking more exotic views. Given the strong issuance on a relative basis in inflation-linked notes this year so far, there’s no doubt that retail investors are seeking higher returns and would be comfortable in taking more risk as a result. This could very well lead to more exotic structured notes, whether it’s callable or range accruals or some other new structure that we haven’t seen before.

Prabhat Arora: I am optimistic that the dealer community can innovate to make the inflation option market much more liquid and balanced. Exotic structures are a great source of volatility supply for the Street at relatively cheap levels. That greed will, in a way, force dealers to think outside the box and come up with new structures to satisfy the growing demand from investors for inflation options.

Antonio Giampaolo: I think it’s very attractive to draw a parallel between what is happening in the UK with real-rate swaptions, in euro with payer-receiver inflation swaptions and what might happen in the US. It would be nice to see the market for more structured notes taking place very quickly. The US market is characterised by more conservative fixed-income investors. What’s more, the regulatory constraints for US onshore investors are such that more complex structures that are easily constructed and sold in Europe are a lot more challenging in the US. It’s a case of more education and more work to be carried out by the banking industry, but I share the expectation that this is something that should and will happen. I’m only a bit more cautious. I can see that the efforts being put in to push the more exotic structures in the US are based on the expectation of attractive returns but it just won’t happen overnight.

BGC wishes to thank all participants for their valuable contributions to this roundtable discussion and we invite any feedback and anyone interested to discuss these issues now and in the future.

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