US INFLATION DERIVATIVES

Developments in the US inflation derivatives The inflation in the US has recently seen a surge in activity, with high-profile trades from North American insurer Fairfax and US investment manager Pimco. Is this the catalyst for further growth? In a forum convened by Risk and sponsored by BGC Partners, a group of senior inflation experts met in New York to discuss the future of the US inflation derivatives market

Risk: What growth in volumes in the US inflation derivatives market has been seen in the last 12 months? The Panel D’Arcy Miell, BGC Partners: Interbank market volumes are up 30%– Barclays Capital, Nikolay Stoyanov, 35% from last year. The options business has grown significantly Associate Director, Inflation Derivatives Trading (NY) since the first trades in 2007, with options now accounting for BNP Paribas, Keith Price, Head of US Inflation (NY) 12.5% of the total volume of trades done in the interbank market. Citi, Carl Bonde, Inflation (NY) We are also seeing a great deal of in US inflation products Deutsche , Allan Levin, Head of Inflation, North America (NY) from a lot more . More participants are coming into the HSBC, John Harrison, Head of USD Inflation (London) market and there is definitely more liquidity being provided. JP Morgan, Alvaro Mucida, Executive Director, Head of USD Inflation Trading (NY) Risk: How has the overall US inflation market developed over Nomura, Michael Anthony, Vice President, USD Inflation Trading (NY) NOTrecent years? FOR REPRODUCTIONRoyal Bank of Scotland, Raj Shah, Inflation Trader (Stamford, CT) Dariush Mirfendereski, UBS: What is most striking about this UBS, Dariush Mirfendereski, market is that the underlying Treasury inflation-protected securities Managing Director, Global Head of Inflation Linked Trading (London) (Tips) market is the largest in the world. Yet the derivatives market BGC Partners, D’Arcy Miell, Global Head of Inflation Products in the US has always been an underperformer compared to the eurozone and UK markets, which are both actually smaller on the cash side. There are good historical reasons for this The dilemma in the US market is that a lot of people would discrepancy. D’Arcy’s numbers cover most of what the market has buy Tips for the inflation protection but they may not because done in the broker market. To estimate the total market size, i.e. they’re locking in low yields. If there were corporate inflation-linked to include end-user trades, one can typically multiply the broker bonds, i.e. some higher-yielding instruments, they may actually get volumes by three in terms of total volumes. You can see similar more involved. In the European market, you get end-users using numbers in 2004 and 2005, then a dip in 2006. But trading volumes derivatives as overlays on top of fixed-rate bonds of all types, and have picked up since and have been gradually growing every year. therefore achieving those high-yielding instruments. The biggest SPONSOREDSPONSORED ROUNDTABLE FORUM

problem in the US was – and still is – that the cost of trading zero- are also important factors. inflation swaps compared to where Tips are trading tends A significant part of Tips to be quite high. People refer to that as the ‘richness of the asset-swap demand comes market’. The main reason for this richness is that the market has from foreign investors who always been driven by one-way demand for inflation swaps with have a global perspective no natural supplier of those swaps to bring prices back down to and look at several Tips-implied levels. markets at the same time. The extreme example is in the UK, where you had the natural Cross- basis is two-way flow pre- crunch, during which period inflation also important, as we swaps traded on average close to fair value. The US only relied on have seen some of these the route of asset swaps of Tips as a way to get supply sources of overseas investors overlay inflation swaps. I call the asset-swap route ‘synthetic supply’ – you a to get this create supply using an existing instrument. Post-crisis, even the UK pick-up in their home Alvaro Mucida market is largely relying on asset-swap synthetic supply. . The term structure of the nominal spreads in each market can have Transaction costs are also a major consideration. Something that a large influence on the richness of inflation swaps. In the US, the may increase transaction costs in asset swaps is the fact that the GC-Libor spread pre-credit crunch was around 20 basis points, while Street is now looking more closely at the funding implications of the 10-year swap spreads were in the 50–60bp range. To achieve their credit support annex with each counterparty. Now banks are a zero carry position holding Tips asset swaps – i.e. the Libor-plus looking at discounting the future cash flows at their home funding payments balancing out the funding payments – you would trade curve rather than just using the local discounting curve. All of these Tips as rich as perhaps GC levels, for example, Libor minus 20, but no recent developments have, to a certain extent, generated some richer. Although they were still trading cheaper than Treasuries, the difference of opinion among dealers over the right level of asset trade wasn’t compelling beyond that flat carry level and the hedge swaps, which clouds the transparency of the market. Getting back fund community collectively settled at trading them at those levels. to the need for liquidity, clients like to see transparency; they like This pricing embedded a richness of about 30–40bp in the inflation to see evidence that they can transact without moving the market swaps, reflecting the difference between 10-year swaps spreads and too much. Asset-swap buying can help create pockets of liquidity the GC-Libor spread. Although the structure of demand met by asset- when there is good demand for inflation swaps on the other side. swap demand was quite similar to the European market, in the latter, This two-way flow allows banks to transact in a decent size without you had a relatively flat nominal spread term structure. GC-Libor was moving the market too much. about 10bp, 10-year spreads were 15bp or, at most, 20bp. That meant Another factor that influences demand indirectly is the price of the richness of the swap curve in Europe was only about 5bp or 10bp the floors. That creates some correlation of asset-swap spreads with for the 10-year , which then reduced the barrier to entry for breakevens because, as breakevens go up, floor prices go down people who wanted to use swaps as overlays. The overall yield you and the other way around as well. When prices go got was good value and you got enhancement from the credit curve. down or demand for deflation protection rises, that increases the The next impediment to the growth of the US inflation swap price of the embedded floor and consequently the asset-swap market was the fact there is a lack of familiarity and a general dislike spread, which tends to generate more demand for asset swaps. of the word ‘derivatives’ in the US. The events of the past two years haven’t really done much to help that. Nevertheless, as we see Risk: How has the US inflation options market developed over the market grow, some of the recent developments, especially recent years? on the options side, are really helping because customers can see Allan Levin, Deutsche Bank: Before talking about recent that you can actually transact in large size. You can see trades of developments in the inflation options market, let me give a brief multi-billion print and, therefore, you see the flexibility of using introduction to the two main types of options that trade most the derivatives side compared to what Tips offers you. Especially frequently. First, we have year-on-year inflation options that typically interesting in what we have seen in the volumes is how the pay out annually. For example, a five-year year-on-year cap with a proportion of options traded has increased over the past few years strike of 3% would pay each year any excess of that year’s inflation and we can only see that increasing going forward. rate over the 3% strike. Year-on-year caps and floors are often embedded into inflation-linked notes issued by dealers, mainly Risk: If asset swaps are so important for the development of the into the retail market. The US inflation derivatives market, what else drives the demand for second type of is them? the zero-coupon option. Alvaro Mucida,NOT JP Morgan: To understandFOR the demand forREPRODUCTION asset These make a single swaps, we need to look at the overall state of the market place, in payment on the maturity terms of risk appetite versus need for liquidity. When the market is in date. For example, a crisis or risk aversion mode, investors allocate resources in the most 10-year 0%-strike zero- liquid assets and avoid alternative types of investment and we see a coupon floor would large drop in demand for asset swaps. When the market normalises only pay out if inflation and investors seek alternative ways to enhance their yields, we start has been cumulatively to see more interest in alternatives like Tips on . Credit negative over a 10-year spreads are also a major driver. If credit spreads are wide, that tends period. In terms of upfront to reduce interest in asset swaps in general. Relative levels of asset premium, the zero- swaps versus nominals and inflation-linked bonds in other countries coupon options tend to Allan Levin US INFLATION DERIVATIVES

be cheaper than year-on-year options as they are less sensitive to derivatives space, the largest impact is the mismatch in seasonals spikes in the level of inflation, as deflation in one year may be offset amongst various different banks and the assumptions made. If by high inflation in another year, resulting in a reduced payout on we move to a central -system mechanism, collateral will maturity. The 0%-strike zero-coupon floors with five-year and 10- be posted daily and we’ll all have different valuations feeding into year maturities are especially liquid as they are almost identical to the same system. In reality, we need to have a centralised number the redemption floors built into on-the-run Tips. that is consistent among all of us. The question is, do we move to In terms of recent developments in the market, the growth something similar to a London -style mechanism in the past year has been astounding. This has been driven by whereby the central clearing house takes various types of collateral? divergent views on the likely course of inflation and concerns This brings the next question of what types of collateral will we be about tail risk, with respect to both deflation and elevated levels of allowed to post and the impact of that on the discounting methods inflation. At the end of last year and for most of this year there has that we all use ultimately on these derivatives themselves. It is often especially been large-size trading in 10-year deflation floors. Recent thought that cash-only collateral is the easiest mechanism for various press articles have highlighted some of the participants that have different discounting methods, which will ultimately be discounted been involved, as well as the rationale behind the trades. back at the overnight rates. However, if Tips were eligible collateral, It was reported recently by The Wall Street Journal that a North then that raises a new discussion on whether or not Tips asset swaps American insurer had bought in the region of $22 billion of should be the discounting method or, ultimately, whatever the most deflation floors. The rationale behind the trade was actually difficult repo or collateral would be at that clearing house. quite interesting. The insurer was naturally long equities and The second thing I want to talk about is pension reform and the corporate bonds. Accordingly, as long as the economy recovered potential for that in the US to move towards what we see in the well, they would do well as an institution. However, they also UK. Obviously we are entering a very low rate environment where gave consideration to their worst-case scenario. The insurer was we have defined benefit pensions that have a fixed percentage of very concerned that a Japan-style recession and corresponding payout associated with historic return. Ultimately, I think that there deflationary scenario could happen in the US. They needed an will be another reform that would potentially suggest something insurance policy on the economy to offset corresponding losses on like the UK mechanism, which is inflation plus some kind of return. their equity and corporate bond portfolios. The zero-cost deflation That could potentially cause our market to look like the UK market floors were viewed as a very cheap way to hedge this particular tail on an ongoing basis and, ultimately, cause the derivatives market risk. Essentially, it would give them an instrument that would pay to grow substantially. out when they would most need the money. On the other hand, it was reported that a large US asset Risk: What about the role of seasonality and other risks? manager, Pimco, had sold billions of dollars of the same option. It Nikolay Stoyanov, was interesting to note that Pimco’s rationale was quite different Barclays Capital: because they were in a very dissimilar situation. Pimco was Seasonality had not been naturally long these options by virtue of being a large holder in fully appreciated in the Tips. As Tips have these options embedded, Pimco was in the inflation market until position to sell these options on a covered basis. This opportunity a couple of years ago, allowed them to monetise the value of the embedded options. both in the case of the The large trading that we had seen in zero-coupon options had derivatives and the cash two major implications for the market. First of all, it has generated markets. Most of the cash a great degree of relative-value trading. For example, participants bonds have January or taking views on five-year versus 10-year options, taking views on July maturity dates. July year-on-year options versus zero-coupon options, etc., has resulted maturity dates happen in improved liquidity throughout the option market. Perhaps to enjoy consumer price Nikolay Stoyanov even more relevant is that the recent press on these options has indexes (CPIs) that are on a triggered a significant amount of interest from new clients. We’ve seasonal basis, higher than the January. So, in the Tips market, until a seen many new participants familiarise themselves with and begin couple of years ago, you could – even with moderate correction for to trade these instruments. seasonality – find mispricings on the curve. The derivatives market More recently, there has been a noticeable shift in focus from also did not incorporate seasonality quite as much. Then the Treasury fears of deflation to that of hyperinflation, given the potential for started issuing April notes with five-year maturities. In fairness, there NOTadditional quantitative easing;FOR for example, there REPRODUCTION has been investor are three long-dated April issues, with maturities in years 2028, 2029 interest in selling floors and using the proceeds to buy inflation caps. and 2032, but the seasonality impact in terms of basis points is small As an active participant in the inflation options market, it has been for such long maturities. So now we have a few points – we have very exciting to be involved in the development of this market. We April, July and January points – so the market started appreciating anticipate that the rapid growth will continue for some time. the differences and has started pricing it in the Tips market, as well as the derivatives market. However, there is also the complexity of the Risk: How might forthcoming developments in accounting and embedded floor options, which are more valuable for the April issues regulation impact the market? that enjoy higher base CPI than the corresponding January or July Michael Anthony, Nomura: It is something that is going to have a issues around the same maturities. This difference in the optionality substantial impact on the market for the foreseeable future. There value complicates the deduction of the implied seasonal factors. are two main potential items of regulation that will ultimately be The derivatives market has the additional difficulty in that you would a good thing for our market, the larger of which is the discussion have to map out the full seasonality curve for any other month that is centred on central clearing for derivatives. ParticularMichael to the Anthony inflation not mapped out by the Tips market. SPONSOREDSPONSORED ROUNDTABLE FORUM

Based on past market behaviour, there seems to be a significant seems like an obvious disparity in terms of how different participants value seasonality. trade. Another example In terms of estimating seasonality from past data, there are a would be for financial few econometric techniques out there to do that. One can use a institutions who are under parametric approach, which basically fits a smooth parametric curve pressure from regulators to to the data to describe the trend and then picks out and averages increase their holdings of the residuals for each corresponding month. The non-parametric liquid assets to hold Tips, approach, which is probably the more favoured, uses a form of a which are regarded as the moving average to smooth out the series and the residuals of each highest-grade collateral, month to the trend are used to calculate the seasonal factors. There instead of Treasuries are complications, however. When you have a one-time event, saving them up to 40bp. Hurricane Katrina being the most notable recent example, then the The challenge in getting econometric estimation becomes more difficult. In fact, the Bureau these types of accounts John Harrison of Labor Statistics revised their own seasonality estimates a couple involved in the market is in of years back when they decided to correct for the Katrina effect. I delivering the Tips asset-swap package in a form that overcomes suspect a more developed CPI fixing market would bring into line the the system and accountancy issues. seasonality estimates between different dealers in the market. Another risk associated with managing inflation-linked derivatives Raj Shah, Royal Bank of Scotland: It depends on who is looking at portfolios is the CPI fixing risk. The most liquid inflation swap is the the asset swap in terms of value. One of the newer participants this zero-coupon inflation swap, which basically amounts to a single year has been some of the smaller regional banks. Their funding payment at maturity and is affected a lot by the last couple of levels have improved dramatically from last year and now they can prints prior to the maturity. This -term fixing risk has become fund at Libor-negative levels. So, when they see 10-year Tips on more significant as many of the original trades done as five-year to asset swap that are paying Libor+50bp, it often provides a much 10-year swaps, being still the most liquid and traded portion of the better return than some of the assets that they held before. Also, curve, come close to maturity. One of the ways people have tried to Tips have the added benefit of being US government credit. manage this risk is by trading energy futures, which to some extent Other participants in the asset-swap market who see value in correlates with the energy components of the CPI number but, them are funds and repo desks. One of the ways you overall, the rest of the components remain largely unhedged. can determine the value of Tips on asset swap is to compare them The other risk I want to talk about is the year-on-year swaps with nominal bonds on asset swap – that’s the nominal bonds that versus the zero-coupon inflation swaps. Year-on-year swaps used trade against the Tips to form the breakeven . to be more popular when there was larger issuance of inflation- Although we don’t have the same sort of spread of ASW spread linked notes, which in their most common form pay year-on-year levels that we did last year between the two, I think that in the sub- inflation, but, as the corporate issuance subsided in 2004/2005, five-year sector we still see decent spreads. We know that repo desks so did the interest in year-on-year swaps. Nevertheless, there is a are looking for spreads of 20–25bp – they are happy to lock that significant number of those swaps still on the books. Zero coupon spread in and take the MtM risks between the Tips and the nominals. swaps are model-independent. However, in the case of year-on- We might face a few hurdles going forward, though – the main year swaps, because both start and end CPI values are set in the one being supply. Tips are probably going to grow to $125 billion future, there is model dependency, and the convexity correction next year and that could put significant pressure on the asset-swap depends on correlation factors that are quite hard to estimate. levels. We’ve had a very strong rally this year, so there are some The last thing I want to talk about is the options market. The participants who look at cross-currency market trades and we are options market is still relatively illiquid. It is very difficult to price and getting to levels where UK linkers are cheaper on an asset-swap hedge options that are with off-market strikes. Now we talk about basis compared to Tips, and I think you might see some portfolios the liquidity of the zero-coupon inflation options, but most of the unwinding Tips and moving into linkers on asset swaps. trading is really done around the 0% strike floor, because the latter is essentially embedded and derived from the most recent Tips Dariush Mirfendereski: One of the differences worth highlighting issues. However, managing options with other strikes or maturities is that, pre-crisis, the buy-side for inflation-linked asset swaps was is a bit more difficult. mostly dominated by hedge funds, whereas now real money is strongly involved, with Risk: We talked about asset swaps earlier. Do you have any a lot of buy-and-hold thoughts on the current level of asset swaps and whether that is trades. This became true particularlyNOT compelling? FOR REPRODUCTIONnot just in the US market John Harrison, HSBC: I think the answer is yes, but it depends on but also in the UK market who you are. Since the crisis, we have seen a significant tightening of where, pre-crisis, there asset-swaps and are now closer to pre-crisis levels. So, for speculative were very few real-money accounts looking for a quick mark-to-market (MtM) gain, the major asset-swap investors. move has already occurred and no longer looks compelling. But, for When prices became accounts who are looking to invest cash or hold the highest-grade extremely compelling collateral, Tips on asset swap still represent a compelling trade. post-crisis, it wasn’t For example, for corporate treasurers and central banks who simply a slightly positive are cash-rich and risk-averse, selling agency and AAA rated carry trade or a small non-government paper to buy Tips asset swaps to pick up 35bp ; there was a Dariush Mirfendereski US INFLATION DERIVATIVES

massive arbitrage opportunity to get into the trade and that was inflation derivatives, why we saw this big price correction in 2009. Real money is here will encourage more to stay. Nevertheless, it’s still a synthetic route of getting inflation- investors to participate swap supply back into the market. Despite the asset-swap price in the US inflation correction, they’re still relatively cheap because there is demand for options market. The inflation swaps. Tips asset swaps will continue to trade cheap until increased interest of we get natural supply of inflation swaps. inflation options, floors One other area worth pursuing is that there are a lot of buy- in particular, is also a and-hold Treasury investors, the guys who have billions in their function of the current portfolios and they may not be too concerned about liquidity. expensive levels of If you can get those investors to instead buy Tips and put on inflation . Both an overlay swap to switch into fixed, they effectively construct year-over-year and a portfolio of Treasuries at a higher yield. They’d be holding the zero-coupon floors same issuer’s paper, but getting a pick-up over the trade at historically Carl Bonde they were getting before. That is another way of getting investors rich levels and, at these involved to counter any moves that may sharply cheapen asset levels, investors are happy to take either side of these trades. swaps as a result of market dislocations. Going forward, I think we will see increased liquidity across various products in the inflation volatility space as more and more John Harrison: Looking at the difference in the asset-swap-spread investors get involved. structure in the US and the UK, you can see the effect that the pension fund buying of asset swaps has had in the UK and the Risk: Do you have a view on where inflation volatility is and is potential for further upside in the US. The pension funds have the that level justifiable? advantage of large balance sheets, long-term investment horizons Carl Bonde: Over the last six months there has been much talk and (because of their liability-driven investment (LDI) history) a about disinflation and deflation, and low-strike inflation floors have capacity to transact inflation swaps. As the pension funds are become quite expensive, both in terms of year-over-year and zero- driven by a Libor-linked target for asset returns and are looking to coupon options. This is an effect of inflation expectations trending invest money for 30+ years, they are relatively indifferent to buying lower and volatility becoming richer. At the moment we have a index-linked asset swaps compared to nominal swap spreads. This skewed picture where low-strike volatility is expensive and high- has resulted in the pick-up compared to nominal bond narrowing strike volatility is cheap, reflecting the view that the market believes from five years out to 50 years compared to the US where it slopes there is a higher probability of deflation than hyperinflation. This up out to five years and then is largely flat. picture will most likely change as the Federal Reserve is expected to embark on another round of quantitative easing, there has even Michael Anthony: This is obvious, but we’re entering a point where been talk about specific inflation targeting. Fears will probably shift two-year yields are at 49bp and five-year yields are 1% and 1.25%. away from a low-inflation scenario to a high-inflation scenario and The additional 10–15bps that you earn from a Tips asset swap the probability of higher inflation will increase and, in doing so, is going to draw a lot of investors. We’re potentially entering an low-strike volatility will become cheaper and high-strike volatility environment whereby a new set of investors will come into the will become richer. It’s difficult to say exactly by how much. Some product because of what yields are in absolute terms. say there might be too much inflation, it’s hard to say. Personally I don’t think so, as there are still problems like unemployment Allan Levin: There is a view that increased issuance of Tips by the running at the highest rate in two decades, which has a negative Treasury isn’t necessarily going to widen the Tips asset-swaps spreads. effect on inflation. Overall, I believe that the probability of high In fact, part of the logic of the US Treasury is that increased issuance inflation will increase and high-strike volatility should become in Tips – as long as it’s done in a regular and predictable way, which is richer and low-strike volatility cheaper in this case. the way they plan to do it – will actually improve liquidity in the asset class and make it more attractive as an asset class to a broad array of Alvaro Mucida: One of the reasons why high-strike caps are investors. There is a clear possibility that a reduction in the liquidity relatively cheap at the moment is because, in the first quarter of premium in Tips as a result may actually richen Tips asset swaps. So, in the year, there was a fair amount of structured note issuance with my mind, it may actually be an attractive entry point to invest in Tips embedded caps, which brought some supply of caps onto the NOTasset swaps now, prior toFOR the liquidity risk premium REPRODUCTION reducing. Street. The volume of these caps that went through the market isn’t large enough to provide supply for long. If investors started Risk: What do the recent big trades between Fairfax and Pimco to come and lift these caps in size, the Street would be taken say about the buoyancy of US inflation options, and do you out of their legacy positions from these structured notes pretty think this will encourage more participants to enter the market? quickly. This supply was mainly in the five- to seven-year sectors, Carl Bonde, Citi: These trades recently made headlines after which coincides with the cheapness in the caps. If investors take details about them were published in two articles in the financial advantage of the current low breakeven levels and low implied press. After these trades became known to the broader financial volatility for these high-strike caps (at least compared to the floors) community, we saw a drastic increase of interest and enquiries and start to buy them, the skew will definitely reprice very quickly. in inflation volatility products from various investors. This is both We’ve talked a little about year-over-year options. In Europe, from accounts already active in the US inflation market and it’s not uncommon to find contracts indexed either to local CPI from accounts not previously active. So, yes, I think the publicity or European CPI with embedded floors. If we saw more of these these two large sophisticated investors have had, with respect to contracts in the US – companies or investors who are receiving cash SPONSORED FORUM

flows, through a lease or any type of future revenue stream with Risk: Whenever we talk about the US market, we tend to make embedded inflation floors – they could monetise this by swapping comparisons to the UK market. What do you think are the biggest the indexation out and providing supply of year-on-year volatility. It’s differences between the US and the European inflation markets? true that in the US there are very few of these contracts but, as long Are there any lessons that the US could learn from Europe? as investment bankers are aware that inflation volatility is rich, they Raj Shah: It has been could help their clients during the negotiation of contracts to try mentioned a few times and insert these floors because they know that they would be able that one of the big to monetise it and get some extra value. So there is an education differences is regulation. process – we need to educate bankers and clients. If anyone in a In Europe and in the position to negotiate a contract manages to insert inflation volatility UK, pension funds and there, there is definitely value to it. So I think that is one alternative insurance companies are path to generate some year-on-year inflation volatility supply. required to hedge and manage their inflation Carl Bonde: Another way to get natural supply of inflation volatility exposures. There are no is the development of inflation . An active market in such requirements in inflation swaptions will enable dealers to issue callable notes to the US now, although retail investors, which will provide much-needed supply of inflation potentially there could Raj Shah volatility. At the moment, without an inflation swaptions market, be. That causes big callable notes on inflation have too much model risk in order to be differences in the way people behave. For example, the long end competitive with callable notes in the nominal rates space. of the US inflation curve has very few natural buyers whereas, in the UK, there are many. We complain about our real yield levels Keith Price, BNP right now looking expensive when 10-year Tips go to 65bp in real Paribas: The broader yield, but 40-year UK linkers are trading at 50bp. It shows there is solution here is that very strong demand because of this regulation. we need to increase Another difference is the avenues of supply. In the US, you only participation, not only have the US government supplying Tips and so you can only get in the derivatives space zero-coupon supply through asset swaps. In Europe and the UK, but in the options you have private finance initiatives and utility companies that are space. We’re going happy to provide some sort of demand to the market. That is quite through a natural important because there are real-money accounts that like to progression at the diversify. They would maybe like to buy some corporate linkers or moment. The European have another avenue of gaining inflation exposure, rather than just market has always buying Tips or inflation swaps. been very developed. Another difference is the development of the two markets. The Keith Price We have participants European inflation market in particular tends to be very efficient. It’s who are natural payers down to the number of people involved in that market compared linked to CPI, we have pension funds that are natural receivers, with the US. Whereas a lot of the investors in the US tend to be we have PFI projects, and so on. But, as this market becomes less buy and hold, in Europe you have more people who tend to be on opaque, partially due to people like D’Arcy who are now publishing the other side. It’s an important difference because we saw in the volatility levels that we can give to our risk managers, and I’m 2008 crisis that the European inflation market recovered a lot faster assuming end-users can also give to their risk managers to develop than the US market. Sometimes the inefficiency provides great their own volatility surfaces, this will encourage people to come opportunities for dealers and accounts to make a ton of money, into the market. We saw the financial press and the coverage of the but other times you’re stuck with risk that you don’t like. For the big deflation insurance buyers in the market. You don’t know how long-term health of the US inflation market, we need to move many calls I got, asking: “Really? You can buy those things? What towards that level of development and efficiency. is that? What is a floor? You can protect against deflation in this manner?” Regardless of where you see valuations – we can argue Risk: Is that something that is improving? about that all day, and maybe year-on-year is a bit rich. Personally, Raj Shah: The market is developing. One thing that people think is I think volatility is a bit rich compared to volatility, going to improve liquidity is increased issuance. I don’t necessarily but you still have people in equity markets or some fast money think that’s the case. The US market is already the biggest inflation- accountsNOT who like volatility, and theyFOR look at inflation volatilityREPRODUCTION and linked . I don’t think increasing supply actually does they say, “you might think it’s expensive, we think it’s cheap”, and translate into an increase in liquidity. An important development they’re going to buy it. But, as we get more exposure and more this year is the addition of a lot of new dealers because that means liquidity, it will attract end-users and then maybe we can come up that, when you want to hedge, there are more chances of doing so. with more ingenious ways to allay our year-on-year risk and we’ll This is especially evident in the options market. It is improving, but be able to sell it on to somebody. We’re in the midst of that right there is some way to go before we’re at an efficient level. now, and you see the growth in the inflation option market this year. You’ve clearly seen that it’s moving in that direction. I don’t John Harrison: One bit I’d add to that is on the very long end of think there’s anything that we as a group are going to be able to the curve. The 30-year bond that has just started to be issued has do intentionally to spur that more than we have, but hopefully we proved quite difficult to trade so far this year as the main hedge can keep on. against it has been the 2029 bond, which has made the spread US INFLATION DERIVATIVES

volatile. If the Treasury sticks to the plan of increased issuance, we Higher inflation tends to attract more people to the market. will end up with a group of 30-year bonds, which can trade against Alas, many people tend not to be concerned with inflation when each other, hopefully reducing the volatility of the 20-year to 30- the published CPI numbers are low, but become concerned year spread. As for who would be a natural buyer of the long bond when those numbers start to print high. Unfortunately, by that issuance, the obvious answer is pension funds. Pension funds have time the market-priced future inflation is already high, not quite long-term inflation liabilities and the fact that they are not realised the best time to hedge. One should try to hedge inflation when on does not mean they should not be hedged. there is little concern about it because that’s when the hedge would be cheaper. It is somewhat ironic that, from a market- Keith Price: A bigger hurdle with pension reform is the cultural maker point of view, it feels that some hedging against deflation issue. Our pension funds have liabilities, but Americans love is a business hedge, as trading volumes tend to rise with higher equities – they have always loved equities. To persuade a pension inflation prints. fund to divert from that strategy is going to be very difficult without proper legislation. Even in the UK where it is less ‘equities-centric’, Risk: Does everyone agree that high inflation is favourable for it took legislation to get people to employ their LDI strategies. the US inflation market? But, here in the US, people are not going to want to match those Michael Anthony: It certainly makes things more attractive. You’ve liabilities, especially at the real rates that we’re achieving now – 0.6% got 5%, or what you think is a 5% return on inflation then you’ve at the 10-year or even further up the curve. Until that happens, I absolutely got to get more people involved in the product but, as don’t see the overall development of the derivatives market taking I mentioned before, people are happy to keep this risk oftentimes off like it is in the UK or even in Europe. However, we are making unless it becomes something that’s a valid return and a potential substantial steps. We need more dealers. I’m always happy to hear profit, it’s just not going to be interesting for many people. of new dealers coming to the market, especially a dealer who wants to take risk because it makes it that much easier for me to lay my Keith Price: It is an interesting phenomenon we saw in the risk. Hopefully their client base is different from my client base. The second half of 2009, when we got stuck with the year-on-year more the Treasury does issue, the more liquidity we will have and prints that were much higher, the retail space just exploded. We the more developed the derivatives market will become. saw $400 million/$500 million of new capital coming into new products, exchange-traded funds, Tips funds in particular. Where Michael Anthony: We’re the unsophisticated investors thought they were protecting all sitting around this table themselves, I don’t think they thought of it as much as a macro debating ways to increase play as a reaction to financial media and a re-normalisation in Tips the number of people breakevens. But they saw the outperformance of Tips and inflation- active in the inflation related products to nominal products, we saw a huge influx into space, whether it be zero these products. These were real rate products and so, as we see coupons, options or Tips. a decline in expected inflation over the next couple of years, it The US Treasury has a would be more muted. We’ve seen real rates go straight down. So mechanism whereby they in actuality, the return in these products would have been much think that this increase greater so far this year versus what it got in 2009. in issuance is going to solve this problem and Risk: Disregarding the actual level of inflation itself, how do we Michael Anthony everyone’s going to get see the US inflation market progressing over the next few years involved. But I think that in terms of liquidity, products and themes? the real question we have to ask is: is regulation the only reason Keith Price: As inflation becomes increasingly prevalent in today’s the European and the UK markets work? Is there an actual need for financial lexicon for a myriad of reasons, including quantitative investors to hedge inflation, or is inflation something that people easing and deflationary scares, the future of the inflation are generally happy to just hold either because they think it’s mis- derivatives market looks exceptionally bright and we stand to be priced or they think it’s part of their natural life and they’re happy one of the major beneficiaries. With major focus on inflationary to keep whatever risk they have? To some capacity, we need to ask and deflationary risks, we have already begun to see the natural ourselves as a group of derivatives market makers: is regulation the progression and dynamic tranformation of our market through ultimate endgame for the US derivatives market? Personally, I think increased liquidity and innovative new approaches to inflation NOTthe answer is most likely FOR yes for a variety of reasons. REPRODUCTION I think, given hedging and speculation. As evidenced by this forum, there is the way the world has changed and the way that we are now in an renewed interest in our product. Only two years ago I would be extremely low-yield environment, it becomes much more relevant sitting here with three of my counterparts and not eight, and this than it used to be, particularly for pension funds that may not be speaks to the health and resurgence of our market. Increasing able to meet their obligations. demand from clients is being met on several fronts and I see that trend continuing. Liquidity will continue to improve and pricing Risk: Does anyone have any thoughts on where US inflation will continue to become more transparent. I believe trend growth might be headed and how that might affect the development of in these products will far outpace growth in the majority of other the market? interest rate derivatives markets and should be led by increasingly Nikolay Stoyanov: It is probably more of a bi-model distribution liquid inflation options activity. As our options market develops, because inflation prints tend to be somewhat auto-correlated, possibly this will lead to a structured product market that may one so the trend tends to persist for some time. If I have to choose day become tradeable over the counter. Overall, I am exceptionally between the two, I think that inflation would go up. optimistic about the future possibilities in my market. SPONSORED FORUM

Raj Shah: One thing that is possible is the Raj Shah: One of things that we’d mentioned development of Tips futures. The Chicago Board is the Federal Reserve considering another of Trade has looked at this in the past and they round of quantitative easing and the risk of didn’t go forward with it because they didn’t high inflation associated with that. The way think there was enough demand. But, in the the Fed is thinking about quantitative easing is scenario of significant, new demand for Tips, we that they want to avert disinflation. That is what could see development of Tips futures, which they are looking to make happen. Quantitative could give you a lot more liquidity. That would be easing doesn’t directly affect inflation, but it can good for the industry. increase inflation expectations, which might give us more power bargaining wages and Allan Levin: One clear development that we perhaps increase consumption. The fact is that are going to see is that there will be new ways consumers’ balance sheets are still very bad, so in which to access the inflation market, whether D’Arcy Miell we’re probably going to have a period of low it be through futures, inflation-focused funds inflation rather than deflation or high inflation. or insurance products referencing CPI. Investors want convenient access and there will be efforts made to fulfil this need. In addition, Alvaro Mucida: We’ve talked about swaptions and other, more there is going to be a trend towards more exotic products. Many complex, innovative products, but there is still quite a bit of of the lightly structured products that are currently available in the divergence among the Street’s models for options. For things nominal market will gradually migrate to the inflation market. that have been around for a long time, like year-on-year inflation swaps and options and forward-starting swaps, there isn’t yet a Carl Bonde: I agree with that. Going forward, I think we will see a real consensus about what model is best and how to calibrate it to broader scope of inflation products being offered to clients and calculate the convexity adjustments, for example. I think there is traded in the interdealer market. However, we are not there yet; at still some work to be done before we can actually move forward the moment we do not have some of the fundamental building and start trading more complex products that depend on these blocks like inflation swaptions, for example, which is important in more basic building blocks, but we are definitely moving in the order to price more exotic derivatives such as callable contracts on right direction. I think we are experiencing a kind of virtuous cycle inflation. Most dealers can probably price these types of trades but at the moment, with client interest generating press about the there is still too much model risk, which you will have to warehouse product, which in turn generates more client interest, which helps until this risk can be offloaded. As we get more players involved liquidity and spurs growth. and liquidity improves, I think there will be a natural development of more exotic inflation structures. A key factor to getting this John Harrison: I’m optimistic about the US inflation market – with going is to educate accounts starting with standard options to the increased issuance of Tips from the Treasury, the amount of more complicated structures and show customers the various coverage in the press and the amount trading in other currencies – opportunities there are in the US inflation market. I think there are clear upsides to the US inflation market over the Inflation seems to be on everybody’s mind at the moment. next couple of years. Accounts are concerned about inflation being too high or too low. Liquidity in the interdealer market is at the highest levels ever, which Michael Anthony: Just to look at the big picture again, there’s means that we can provide our clients the very best possible service a perfect storm forming for this market to truly take off – the because we can offload some part of the risk. Also, most dealers culmination of increased issuance from the government, massive have experienced increased interest from customers in the inflation support from the Treasury, potential reform in many capacities that market. Given all these facts, I am positive about the current state will really allow the derivatives market to benefit significantly. The and future of the US inflation market. one thing that we all have to take away is managing the challenge to help the market understand that this is a real risk for them and Keith Price: I think that, in our space, we’re in a healthy, positive space. it’s something they need to consider and be concerned about. I think we’re growing, we have a robust market. Visibility has increased due to press coverage in the eyes of clients. Transparency has increased, BGC wishes to thank all participants for their valuable contributions to which is always helpful. Among us, liquidity has increased. We’re at this forum and we invite any feedback and anyone interested to discuss critical crossroads for the macroeconomic perspective. Will quantitative these issues now and in the future. easing round two or round three work? I don’t think that increasing people’s inflation expectations will give them purchasing power, I think that will NOTbe more for the labour market. FOR Going into a Japanese REPRODUCTION scenario will be very horrible for us as a whole, not just as inflation traders, Salvatore J. Trani but as a country. So I think it’s very critical but, either way, the focus Executive Managing Director is on inflation. At a recent conference recently, someone asked me if T. +1 646 346 7215 I believe in inflation or deflation. I said yes. As long as that scenario is E. [email protected] true, it’s good for us. We’re a very innovative group and I think that, with D’Arcy Miell professionals like ourselves, with our structures and with our clientele, Global Head of Inflation Products we will always be trying to find a solution for a problem. As general T. +1 646 346 7409 liquidity increases in this market, we’d be able to come up with much E. [email protected] nicer solutions for the end-user. I don’t see why any progress should be www.bgcpartners.com stopped there. Hopefully 2010 for us will be like 2004 was for the UK. INFLATION RISK Nikolay Stoyanov, Inflation Derivatives Jeremie Banet, Head of US Inflation and Trader, Barclays Capital CAD Rates Trading, BNP Paribas Nikolay Stoyanov is Associate Director at Jeremie joined BNP Paribas Equity Barclays Capital where he trades US inflation Derivatives in 2000 in an interest rate derivatives, total return swaps, and structured trading support role. He then traded CHF inflation-linked products. Prior to joining the and Scandies swaps, assuming his current inflation trading desk in 2004, he worked in position of head of US Inflation Trading in quantitative research at Barclays where he 2007. He has a master’s degree in economics developed pricing and trading for various from Dauphine University, France. instruments and markets, which included rates, commodities, and credit markets. Nikolay holds a PhD in physical chemistry from the Massachusetts Institute of Technology.

Allan Levin, Head of Inflation, Joshua Schiffrin, Head of US Inflation North America, Deutsche Bank Products, Since joining Deutsche Bank in 2004, Allan Joshua Schiffrin joined Goldman Sachs in has had a number of roles within Deutsche 2001 and has been involved in trading the Bank’s Global Rates Business, including head US inflation markets since 2003, having of rates structuring, North America, head previously traded US agency . He is a of structured/exotic rates, North America graduate of Duke University holding degrees and, most recently, head of inflation, North in mathematics and economics. America. Allan is a graduate of Columbia Business School and a Fellow of the Society of Actuaries.

Mihir Worah, Managing Director, D’Arcy Miell, Global Head of Inflation Head of Real Return Products, Pimco Products, BGC Partners Mihir Worah is a Managing Director in the D’Arcy Miell is global head of inflation Newport Beach office, a Portfolio Manager products for BGC and is responsible for and Head of the Real Return Portfolio the growth of BGC’s inflation derivatives Management team at Pimco. He was business and cash businesses. D’Arcy previously a member of the analytics team joined BGC in 2003 and has spent his and, prior to joining Pimco in 2001, was career establishing and developing various a postdoctoral research associate at the markets and brings with him 25 years of University of California, Berkeley, and the experience within the financial markets Stanford Linear Accelerator Center. He has industry. seven years of investment experience and holds a PhD in theoretical physics from the University of Chicago.

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BGC Partners is a leading global intermediary to the wholesale financial markets, specializing in the brokering of a broad range of financial products, including securities, interest rate swaps, foreign exchange, equities, equity derivatives, credit derivatives, commodities, futures, structured products and other Tel +1 646 346 7409 instruments. BGC Partners also provides a full range of services, M. +1 646 201 8994 including trade execution, broker-dealer services, clearing, E. [email protected] processing, information, and other back office services to a broad range of financial and non-financial institutions. www.bgcpartners.com