Close Short Euro Payer Swaption, Sell USD Payer Swaption‏

The position was established on 25 June (link). The payer swaption was sold for a premium of 119 ticks and is now bought back for 57 ticks. Even though we believe it will expire out of the money, we decide to lock in more than ½ the received premium of a six-month option in just two weeks. At the same time, we enter a short payer swaption in the USD swap markets, where we believe risk-reward is now better.

New trade recommendation: Sell 3M5Y ATM +15bp USD3M payer swaption
Spot ref:1.67%, 3M ATM forward: 1.84%, strike 1.99%

Premium to be received 81 ticks

Profit range at expiry if the 5Y USD swap rate is below 2.16%

Switch from EUR to USD due to better risk-reward
The short position we established in EUR payers has performed as volatility and the underlying swap rate moved lower. The ECB forward guidance supported this move. While we still see value in holding on to the position fundamentally as we believe it will expire out of the money, we see much better risk-reward in closing it down and scaling in to short payer swaption in USD swaps.

In the past two months there has been a significant repricing of the entire US swap curve. The markets were not prepared for this and volatility consequently spiked. Whereas a first rate hike (taking the Fed Funds to 0.50%) was priced in for Q1 2016 at the beginning of May, it is now priced in for the March 2015 FOMC meeting. Last week, when rates spiked the first hike was priced in for late 2014. The money market curve is broadly fair, in our view and we don’t expect it to have much steepening at current levels, since we do not believe the markets can buy into a story where the Fed hikes as early as in 2014. We therefore also believe there is limited upside to 5Y swap rates, hence the 3M forward curve is not likely to be realised. There is a 17bp roll-down in only three months on the underlying 5Y swap rate.

Rather than receiving outright, where we would be more exposed if we are wrong in our directional view, we prefer selling payers out of the money to benefit from the spike in volatility – especially around the belly of the USD swap curve.

The profit range is quite far from today’s spot reference making the risk-reward attractive, in our view.

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