Inflation Hedging It & Trading It

Deutsche Bank Corporate and Investment Bank

Inflation Hedging it & Trading it Doremus Deutsche Bank ClearPath 210x297mm 300944 Proof 01 07-07-2011

Deutsche Bank Corporate & Investment Bank

Winning for our clients: Inflation Derivatives House of the Year. At Deutsche Bank, we are dedicated to setting the stage so that our clients can perform at their best. We appreciate winning awards that recognize the quality of service that we deliver.

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Introduction Why inflation, why now? 6.0 Inflation Options 1.0 Deutsche Bank’s capabilities and credentials in this market 6.1 Inflation Options 1.1 How Deutsche Bank’s inflation offering differs from 6.2 Who are the major players in the options market? competitors 6.3 Option Products 2.0 Market Overview – the rise and rise of inflation volatility 6.4 What are the trading opportunities? 2.1 Components of Inflation indices 6.5 Option Strategies 6.6 Creating Optimal Hedges 3.0 Inflation Linked Bonds 3.1 Inflation Linked Bonds 7.0 Deflation tail risk 3.2 Real Yield and Breakeven Inflation and Inflation Protection 7.1 Deflation Tail Risk: DB 5 Year Note 3.3 Indexation and Breakeven Inflation 8.0 Case Study – Zero-Coupon Option Trade 3.4 Risk Measures, EM Sovereign Linkers, Seasonality, and US TIPS 9.0 Further Reading 3.5 UK Index Linked Gilts, EUR Sovereign Linkers, and other 9.1 Inflation Hedging for Institutional Investors Important Markets 3.6 ILB coupon frequency and settlement characteristics 10.0 Contacts 10.1 Deutsche Bank Global Inflation Team 4.0 Inflation Swaps 4.1 ILS Swaps and Markets 4.2 UK Swaps, Corporate Linkers, and US Swaps 4.3 ILS Indexation 4.4 ILS Pension Fund demand

5.0 Assessing Relative Value 5.1 Linker Asset Swaps and the Leverage Effect 5.2 5 sources of Asset Swap Difference 5.3 What is the ‘Fair’ Price for Inflation Protection? 5.4 Fair Credit Spread of Inflation Linked Bonds 5.5 Hedge with Bonds or Swaps 5.6 Summary

Inflation—Hedging it & Trading it Deutsche Bank Introduction

Why inflation, why now? Inflation Derivatives House of the Year

There has never been a better Deutsche Bank is very strongly The Deutsche Bank inflation time to talk about inflation positioned to advise clients on team has developed this briefing what to do document to:

– Inflation looks set to be volatile – We were recently voted the – Set out the challenges for the next 5 to 10 years Best Inflation Derivatives house and opportunities faced by – Any client with a bond portfolio in the industry by Risk magazine clients is exposed to inflation risk – We have a large global inflation – Explain the products and – Clients with revenues or derivatives trading and strategies we have developed. liabilities indexed to inflation structuring team are especially vulnerable. – We have extensive experience The Deutsche Bank Global of helping clients find inflation Inflation team can help solutions

Inflation—Hedging it & Trading it Deutsche Bank Deutsche Bank’s credentials and capabilities in the Inflation market How Deutsche Bank’s inflation offerings differ from 1 competitors

Inflation—Hedging it & Trading it Deutsche Bank Contents 1.0 Deutsche Bank’s credentials and capabilities in the Inflation Market

Deutsche Bank’s credentials and capabilities in the Inflation Market

We offer a full range of Issuing long dated inflation in large inflation services sizes can be difficult to manage; debt Our primary capabilities are managers turn to the strongest banks demonstrated by our leading position who have the best track record for in the league tables; we’ve also played risk management and distribution – an important role in maintaining order Deutsche Bank leads in this space in the secondary markets, distributing and recycling bonds and swaps across the world. DB is the global leader in inflation-linked bond syndication.

Lead syndication mandates awarded to market counterparties *between September 2009 and February 2011 Source: Bloomberg, Deutsche Bank No. Date Deal DB UBS RBS Barc HSBC GS JPM Nomura BNPP SG Calyon MPS Leads

24 Sep 09 UKTI50 4 1 1 1 1

29 Sep 09 ACGBi25 3 1 1 1

21 Oct 09 BTPei41 4 1 1 1 1

27 Jan 10 UKTI40 4 1 1 1 1

21 Apr 10 BTPei21 5 1 1 1 1 1

11 May 10 UKRAIL47 2 1 1

26 May 10 UKTI50 4 1 1 1 1

27 Jul 10 UKTI40 4 1 1 1 1

14 Sep 10 ACGBi30 3 1 1 1

01 Feb 11 NZGBi25 1 1

Total number 7 6 5 3 3 3 2 1 1 1 1 1

Inflation—Hedging it & Trading it Deutsche Bank 1.0 Deutsche Bank’s credentials and capabilities in the Inflation Market

We are outperforming the competition around the world Deutsche Bank is: – No 1 in ICAP market share for EUR Inflation/Asset Swaps (2009, 2010) – No 3 in ICAP market share for UKRPI Inflation/Asset Swaps (2009, 2010) – No 1 in BGC market share for all US products (Inflation, Asset Swaps, Options) 2010

Fig.1: Fig. 2: Fig. 3: Global Linker Syndications as Lead Total Syndication Size for Global USD Inflation Market by Volume 2010 Manager Linkers (mm) Source: Bloomberg, Deutsche Bank Deutsche Bank Source: Bloomberg, Deutsche Bank Source: Bloomberg, Deutsche Bank Competitors Deutsche Bank Deutsche Bank Competitors Competitors

8 Number of 7,000 Total Syndication 12,000 Syndications Size 7 6,000 10,000 6 5,000 8,000 5 4,000 4 6,000 3,000 3 4,000 2 2,000 1 1,000 2,000 0 0 0 GS GS DB DB ML ML MS MS RBS RBS RBC RBC ANZ ANZ UBS UBS Barc Barc MPS MPS BNPP BNPP HSBC HSBC JPMC JPMC Calyon Calyon SocGen SocGen Nomura Nomura

Inflation—Hedging it & Trading it Deutsche Bank 1.0 Deutsche Bank’s credentials and capabilities in the Inflation Market

We are outperforming the competition in the UK

Fig. 1: Fig. 3: UK Linkers Syndications as Lead UK Linkers Total Syndication Size (mm) Manager Source: Bloomberg, Deutsche Bank Deutsche Bank Source: Bloomberg, Deutsche Bank Competitors Deutsche Bank Competitors 3.5 3,000 3 2,500 2.5 2,000 2 1,500 1.5 1,000 1

0.5 500

0 0 DB UBS RBS Barc HSBC GS JPM Nomura DB UBS RBS Barc HSBC GS JPM Nomura

Fig. 2: Fig. 4: UK Linkers and Nominals Syndications UK Linkers and Nominals Syndications as Lead Manager as Lead Manager Source: Bloomberg, Deutsche Bank Source: Bloomberg, Deutsche Bank Deutsche Bank Deutsche Bank Competitors Competitors 3.5 4,000

3 3,500 3,000 2.5 2,500 2 2,000 1.5 1,500 1 1,000

0.5 500

0 0 DB UBS RBS Barc HSBC GS JPM Nomura DB UBS RBS Barc HSBC GS JPM Nomura

Inflation—Hedging it & Trading it Deutsche Bank 1.1 Deutsche Bank’s credentials and capabilities in the Inflation Market

Integrated trading, structuring Fig. 1: and research Our inflation page on Bloomberg DBII Unlike some of our competitors, Deutsche Bank’s inflation trading, structuring and research professionals work closely together, combining strategic and technical expertise with the macro-economic insights so important to this offering.

Bloomberg Forecasts, inflation linked bonds, inflation swaps and inflation linked options. US options will be added soon (figure 1) Fig. 2: Inflation on Trade Finder – new The market is pricing much more improvements coming soon upside risk than downside risk – contrary to what we see in other markets

Trade Finder Currently being upgraded, it will soon include additional functionality: e.g. forward matrices – five year forward on Eurozone or five year to 25 year forward. In Frankfurt and Mumbai, real live zero coupon lives and forward matrices and cross market indicators will soon be added (figure 2)

Inflation—Hedging it & Trading it Deutsche Bank Market Overview

2 Components of Inflation indices

Inflation—Hedging it & Trading it Deutsche Bank Contents 2.0 Market Overview – the rise and rise of market volatility

All G7 nations issue inflation-linked Industrial country sovereign linker Fig. 1: bonds markets – Other important markets A Fast Growing Asset Class include Australia, Canada and Sweden. Source: Deutsche Bank US ITL Markets AUD: govt suspended issuance in UK DEM JPY Gr FRF SEK US TIPS – the US Sovereign linker 2003, started again in 2009. Sweden: CAD AUD

market is the largest globally with a linkers account for almost 30% of total 1,600 total outstanding, $ bn total market value of over USD700bn govt bond market, higher share than in 1,400 but less liquid than EUR any other industrial market 1,200 1,000 UK – IL Gilts – first issuance 1981; total 800 EM sovereign linker markets - most 600 market value exceeds GBP270bn LatAm inflation markets have long 400 histories; Brazil is the largest market, 200 EUR sovereign linkers - expanding suppression of investment restrictions 0 rapidly; total market value exceeding in 2006 spurred international demand. ‘97 ‘98 ‘99 ‘00 ‘01 ‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09 ‘10 EUR320bn as of now; France, Italy, Chile, Colombia & Uruguay also issue Germany & Greece issue ILBs. Italian, ILB. Israel is big (USD27bn market German and Greek ILBs are linked value). More recently: South Africa, to euro area inflation; France issues Poland, Turkey (2007) and South Korea bonds linked to EUR inflation and (2007) bonds linked to FRF inflation

Inflation—Hedging it & Trading it Deutsche Bank 2.1 Market Overview – the rise and rise of market volatility

Fig. 1: Fig. 2: Weights in the US CPI Weights in the UK RPI Source: Deutsche Bank Source: Deutsche Bank 1,600 1,600 Food and beverages Food and catering 4 1,400 6 Housing 1,400 Alcohol and tobacco 15 Apparel 165 Housing and 6 1,200 Transportation 1,200 257 household expenditure Medical Care Personal expenditure 1,000 7 1,000 88 Recreation Travel and leisure 800 % Education and 800 Communication 82 600 17 Other 600 42 400 400 408 200 3 200

0 0 ‘97 ‘98 ‘99 ‘00 ‘01 ‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09 ‘10 ‘97 ‘98 ‘99 ‘00 ‘01 ‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09 ‘10 Fig. 3: Weights in the EUR Source: Deutsche Bank

Food & beverages Alcohol & tobacco 9 15 Clothing & footwear 9 1 Housing & household services 4 Furniture & household goods Health 7 10 % Transport Communication 3 Recreation & culture 16 Education 16 Restaurants & hotels 7 4 Other goods & services

Inflation—Hedging it & Trading it Deutsche Bank Inflation Linked Bonds

Inflation Linked Bonds Real Yield and Breakeven Inflation and Inflation Protection Indexation and Breakeven Inflation 3 Risk Measures, EM Sovereign Linkers, Seasonality and US TIPS UK Index Linked Gilts, EUR Sovereign and other Important Markets ILB coupon frequency and settlement characteristics

Inflation—Hedging it & Trading it Deutsche Bank Contents 3.1 Inflation Linked Bonds

Inflation Bonds ‘Linkers’ A ‘Canadian style’ Linker pays a ‘real’ Fig. 1: Inflation Linked Bonds (also known as coupon and redeems at 100 in ‘real’ Vanilla Fixed Rate Bond versus Inflation inflation indexed bonds) or ‘Linkers’. terms Linked Bond – Index Ratio = CPI Index on Source: Deutsche Bank Real These are Treasury bonds designed Payment Date / CPI Index on Nominal to cancel the capital eroding effects Issue Date 10% Coupon Principal 160% 9% 140% of inflation. Called TIPS (Treasury – Interest Paid = Fixed Rate * Inflated 8% 120% Inflation Protection Securities) in the Notional 7% 6% 100% US, their interest rate remains fixed but – = Fixed Rate * Notional * Index 5% 80% 4% 60% the principal is adjusted to match Ratio (e.g. 2% * 100 * 1.5 = 3) 3% 40% changes in a price index. – Redemption = 100 * Index Ratio 2% 1% 20% (e.g. 100 * 1.5 = 150) 0% 0 For example: Year 1 2 3 4 5 6 7 9 10 A vanilla fixed rate bond pays a fixed Some ILBs (like US TIPS or OATei/i) coupon and redeems at 100 have a deflation floor, meaning a – Interest Paid = Fixed Rate * principal repayment of minimum par is Constant guaranteed by the issuer – Notional (e.g. 5% * 100 = 5) – Redemption = Constant Notional (e.g. 100)

Inflation—Hedging it & Trading it Deutsche Bank 3.2 Inflation Linked Bonds

Real Yield and Breakeven Inflation Inflation Protection Components of nominal interest rate: With positive inflation, the ILB’s cash – Real yield flows will increase over time to secure – Expected Inflation the investor’s purchasing power. – Risk Premium – Liquidity Premium Compared to a nominal bond early coupon payments will tend to be lower, Issuing nominals means investors need and the final repayment will tend to be compensation for inflation uncertainty. higher.

Linkers save issuers the risk premium The examples below assume an annual by providing certainty about real cash coupon and inflation at 2%. (figures 2 flows in the future i.e. their increase and 3) in purchasing power is ‘locked in’. (figure 1)

Fig. 1: Fig. 2: Fig. 3: Components of Nominal Yield Nominal cash flows Real cash flows (purchasing power Source: Deutsche Bank Source: Deutsche Bank of the CFs) Coupon Linker (2%) Notional Conventional (rhs) Source: Deutsche Bank Coupon Conventional Bond (4%) Notional Linker (rhs) Coupon Linker (2%) Notional Conventional (rhs) Coupon Conventional Bond (4%) Notional Linker (rhs)

14 140 12 120 9% 8% 12 120 10 100 Nominal Yield 7% 10 100 6% 8 80 5% 8 80 6 60 4% 6 60 3% Inﬂation Risk 4 40 Real Yield Expectations Premium 4 40 2% Liquidity 2 20 1% Premium 2 20 0% Index Linked Bond Breakeven Rate 0 0 0 0 1 2 3 4 5 6 7 9 10 1 2 3 4 5 6 7 8 9 10 not’l 1 2 3 4 5 6 7 8 9 10 not’l

Inflation—Hedging it & Trading it Deutsche Bank 3.3 Inflation Linked Bonds

Indexation Breakeven Inflation Fig. 1: To offer inflation protection you need Canadian style linkers are quoted in Indexation Source: Deutsche Bank to: (i) choose a price index, (ii) define real terms and the real price (P) - real precise linking rules. yield (r) relationship is equivalent to 103 that of a conventional bond (c: coupon): 102 Price index: typically a non-seasonally 101 adjusted, official consumer price index ILBs’ value is often expressed in terms 100 of inflation rather than in terms of real 99 Indexation: the ‘Canadian’ model is yields by considering the difference in 98 97 now the benchmark, adopted among yield between nominal and real bonds. 96 others by TIPS, EUR ILBs and new Jan ‘04 Jun ‘04 Nov ‘04 Apr ‘05 Sep ‘05 Feb ‘06 Jul ‘06 UKTi (figure 1) BEI (Breakeven Inflation) is the inflation – Problem: CPI only monthly and rate that equates the expected published with a delay return of an ILB and a comparable Fig. 2: – The price factor used to inflation nominal bond; i.e. if actual inflation BEI ≈ nominal yield – real yield adjust cash flows, the ‘Daily until maturity exceeds BEI, linkers Source: Deutsche Bank Real Yield Inflation Reference’ (DIR), is a linear outperform nominals. Nominal Yield interpolation of 6.0 % 5.5 the two monthly values of the official In practice, the market looks at simple 5.0 4.5 price index three months earlier and yield spreads (figure 2). 4.0 3.5 two months earlier, e.g.: 3.0 Breakeven Inﬂation 2.5 – The DIR for 1 June is the 2.0 1.5 official CPI March (released 1.0 mid-April) BTPei 08 BTPei 10 BTPei 12 BTPei 14 BTPei 17 BTPei 23 BTPei 35 BTPei OATei 12 OATei 15 OATei 20 OATei 32 OATei 40 OATei OBLei 13 DBRei 16 – The DIR for 1 July is the GGBei 25 BTANei 10 BTANei official CPI April (released mid-May) – The DIR for 23 June is : CPI(Mar) + 22/30 * [CPI(Apr) – CPI(Mar)]

Inflation—Hedging it & Trading it Deutsche Bank 3.4 Inflation Linked Bonds

Risk Measures Seasonality Fig. 1: – The concepts of duration and – Seasonal movements in price indices US TIPS total outstanding market value convexity can be applied to linkers mean that inflation accrual is not Source: US Treasury in the same way as for conventional linear 700 USDbn bonds – Quoted real yields of ILB adjust to the 600 – But in the case of linkers, duration changing inflation uplift 500 400 describes the sensitivity of the price – real yields & BEI exhibit 300

to a change in the real rate seasonal patterns 200

– Linkers have a higher duration than – detecting the seasonal 100

same maturity conventionals pattern in prices is important 0 – Convexity rises exponentially with for valuing ILBs 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 duration, for the same maturity ILBs – Estimation of seasonal factors is not have a higher convexity than without difficulties, especially in the nominals euro area where there is instability – There is no consensus on their EM Sovereign Linker Markets precise value – Most Latin American inflation markets have long histories; Brazil is US TIPS by far the largest market, suppression – The US sovereign linker market is the of investment restrictions in 2006 largest globally with total market spurred international demand value in excess of USD700bn (figure 1) – Chile, Colombia & Uruguay also – TIPS were first issued in 1997; in issue ILB recent years, there have been two – Israel has a large linker market 5y, two 20y and four 10y auctions per (USD27bn market value) year; in February 2010 30y TIPS were – More recently South Africa, Poland, reintroduced, replacing the 20y Turkey (2007) and South Korea (2007) – Maturities range from 1y to 30y

Inflation—Hedging it & Trading it Deutsche Bank 3.5 Inflation Linked Bonds

UK Index Linked Gilts EUR Sovereign Linkers Other important markets include – The UK linker market is the oldest in – Euro area sovereign inflation-linked Australia, Canada and Sweden Europe (first issuance 1981) bond (ILB) markets are expanding – AUD: govt suspended issuance in – Total market value exceeds rapidly with the total market value 2003, but started again in 2009. GBP270bn and more than 20% of exceeding EUR320bn today Strong liability related demand from sovereign debt is linked to inflation – France, Italy, Germany & Greece PF and insurance companies – Traditionally bonds have an 8M issue ILBs – Sweden: linkers account for almost indexation lag, but since Sep 2005 all – Italian, German and Greek ILBs are 30% of the total government bond new issues follow the 3M lag model; linked to euro area inflation; France market, a higher share than in any UKTi have no deflation floor issues both bonds linked to EUR other industrial market – Issuance has been weighted towards inflation and bonds linked to FRF the long end inflation – Maturities range from 1Y to 50Y, – Maturities range from 1Y to 32Y, with with issues available on all main issues available on all main points on curve points (figure 1) the curve (figures 2 and 3)

Fig. 1: Fig. 2: Fig. 3: UK Total Outstanding Market Value EUR Sovereign Linker Issuance Sovereign Linkers, Outstanding Volume Source: UK DMO Source: National Treasury Source: National Treasury FR DE Germany Fr (FRCPIxt) IT GR France Italy EUR (rhs) Greece 310 USDbn 35 Linker Issuance Total Outstanding 350 40 EURbn EURbn EURbn 30 300 35 260 30 25 250 25 210 20 200 20

160 15 150 15 10 100 10 110 5 5 50 0 60 0 0

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2003 2004 2005 2006 2007 2008 2009 2010 2011 2013 2015 2017 2019 2021 2023 2025 2027 2029 2031 2033 2035 2037 2039 2041

Inflation—Hedging it & Trading it Deutsche Bank 3.6 Inflation Linked Bonds

ILB coupon frequency and settlement characteristics

Most ILBs have coupon frequency and settlement characteristics in line with the nominal market Price index BBG Index lag Deflation floor Coupon

US CPI-U CPURNSA 3M YES semi-ann

UK RPI UKRPI 8M/3M NO semi-ann

CPI x tob, FR FRCPXTOB 3M YES annual FR HICP x tob, EMU CPTFEMU 3M YES annual

IT HICP x tob, EMU CPTFEMU 3M YES semi-ann

JP CPI x fresh food JCPNJGBI 3M NO semi-ann

SE CPI SWCPI 3M YES (new ILB) annual

CA CPI CACPI 3M NO semi-ann

GR HICP x tob, EMU CPTFEMU 3M YES annual

DE HICP x tob, EMU CPTFEMU 3M YES annual

AU CPI quarterly ACIF 6M YES quarterly

Inflation—Hedging it & Trading it Deutsche Bank Inflation Swaps

ILS Swaps and Markets UK Swaps, Corporate Linkers and US Swaps ILS Indexation 4 ILS Pension Fund Demand

Inflation—Hedging it & Trading it Deutsche Bank Contents 4.1 Inflation Swaps

Inflation Linked Swaps (ILS) – a pure ILS Markets Fig. 1: inflation product as opposed to a real The most liquid ILS are typically those Inflation Swaps rate product linked to the same price index as the

inflation-linked government bonds of (1+BEI)N–1 What is an Inflation Swap? the corresponding market (US CPI-U, The cash-flows EUR HICP ex-tobacco, French CPI ex Fixed – Receive Compounded Inflation from tobacco, UK RPI). Client Start to Maturity: pay one cash-flow Floating CPI(N) – CPIt/CPI0 -1 For the major markets, ZC ILS are –1 – Pay a known Fixed cash-flow at usually quoted for tenors out to 30 CPI(0) Maturity years, sometimes 50 years. – (1 + X%)^t

What is the break-even rate? – Receive Compounded Inflation from Start to Maturity: pay one cash-flow – CPIt/CPI0 -1 – Pay a known Fixed cash-flow at Maturity – (1 + X%)^t

Inflation—Hedging it & Trading it Deutsche Bank 4.2 Inflation Swaps

UK Swaps and Corporate Linkers US Swaps Non-sovereign inflation supply in bonds The inflation swap market has & swaps has grown rapidly in the UK in developed rapidly from 2004, but particular 2006 and H107 remains less liquid than its European counterparts

Price A lack of ‘natural’ inflation swap supply Market Lag CPI Fixing Index translates into structural richness in swap BEI vs bond BEI… and wide linker US CPI-U 3M Interpolated ASW discounts HICP ex Euro area 3M Straight tobacco CPI ex Fig. 1: Fig. 2: France 3M Interpolated tobacco Bond Breakevens vs Swap Breakevens Measures of Relative Value: ASW Source: Deutsche Bank Spread and Z-spread UK RPI 2M Straight USCPI ZC swap rates Source: Deutsche Bank TIPS-implied ZC B/E US Linker Z-spread discount US Linker ASW discount

3.1 % 35 30 2.9 25 2.7 20 15 2.5 10 2.3 5

2.1 0

1.9 TII Jul 18 TII Jul 19 TII Jul 20 TII Jul 13 TII Jul 14 TII Jul 15 TII Jul 16 TII Jul 17 TII Jan 18 TII Jan 19 TII Jan 20 TII Jan 21 TII Jan 25 TII Jan 26 TII Jan 27 TII Jan 28 TII Jan 29 TII Jan 14 TII Jan 15 TII Jan 16 TII Jan 17 TII Apr 28 TII Apr 29 TII Apr 32 TII Apr 13 TII Apr 14 TII Apr 15 0 5 10 15 20 25 30 40 TII Feb 41 TII Feb

Inflation—Hedging it & Trading it Deutsche Bank 4.3 Inflation Swaps

ILS Indexation

ILS Indexation But has fallen significantly during the For FRCPIxt & US CPI, the indexation credit crisis lag convention is the same as for the corresponding inflation-linked bond Main sources: regulated utilities, PFIs, markets property leases, railway companies, – Strong demand has led to a low retailers, supranationals level of real interest rates, lock in low financing costs Alternative supply has led to two-way – PFI projects with inflation component swap market and narrow swap-bond (usually bonds, but typically B/E spread, but swap richness has transformed into ASW) increased again during the crisis – Credit wrapping allowed corporates to issue highly rated debt which is more appealing to institutional investors

Inflation—Hedging it & Trading it Deutsche Bank 4.4 Inflation Swaps

ILS Pension Fund demand Fig. 1: Fig. 3: – In the UK, pension indexation to RPI Real Yields UK Non-sovereign Inflation Supply (LPI) is more explicit than elsewhere Source: Deutsche Bank Source: Deutsche Bank US Other and the pension industry is larger UK Rail FRF Utility than in other European countries 2.5 Real Yields 4,000 GBPm 2.0 – Accounting rules (‘Financial 3,500 1.5 Reporting Standard 17’) have 1.0 3,000 encouraged pension funds to match 0.5 2,500 0 2,000 -0.5 their indexed liabilities more closely 1,500 -1.0 – As a result, demand growth from -1.5 1,000 -2.0 500 pension funds and life insurers has -2.5 0 outstripped supply leading to low -3.0 Maturity 2009 2017 2025 2034 2042 2050 2058 real yields and expensive BEI at the Q305 Q306 Q307 Q308 Q309 Q310 long-end of the curve But has fallen significantly during the credit crisis Fig. 2: – Long-term investors own the UK Non-sovereign Inflation Supply majority of ILB as a hedge for Source: Deutsche Bank their real liabilities UK Non-sovereign inflation supply 10,000 Issuance – All public and part of private sector 9,000 GBPm pension liabilities will be linked to CPI 8,000 7,000 (instead of RPI) from fiscal year 6,000 2011/12 future issuance of CPI 5,000 4,000 linked Gilts looks possible 3,000 2,000 1,000 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Inflation—Hedging it & Trading it Deutsche Bank Assessing Relative Value

Linker Asset Swap and the Leverage Effect 5 Sources of Asset Swap Difference What is the ‘Fair’ Price for Inflation Protection? Fair Credit Spread of Inflation Linked Bonds 5 Hedge with Bonds or Swaps Summary

Inflation—Hedging it & Trading it Deutsche Bank Contents 5.1 Assessing Relative Value

Linker Asset Swap The Leverage Effect Fig. 1: – Investor buys an Inflation Bond Sophisticated investors may not Linker Asset Swap – Investor agrees to pay away all the be able to borrow to buy additional Source: Deutsche Bank cash-flows (P+I) from the bond nominal bonds due to constraints, Inﬂated Notional Inﬂated Notional

– Investor receives in return Libor + hence are willing to give up some of CPI CPI x% until maturity as well as a their excess return

principal payment Linker Investor Some investors just like the pick-up

“The increasing credit exposure, over equivalent tenor nominal bonds Libor + X and thereby return, on a linker on asset swap (figure 2)

asset swap generates significant Notional

outperformance…” For example This is how we expect a Linker to – Daragh McDevitt, Global Head of Inflation Structuring increase in the Eurozone over time Fig. 2: The Leverage Effect Why is this important? Source: Deutsche Bank Inflation Sovereign default is currently very real Libor possibility… like for like exposures 350 Notional need to be carefully assessed for fair 300 value – some investors have increased 250 200 credit risk for very little reward Increasing Credit Exposure 150

100 Constant Swap Notional 50

0 Years 0 5 10 15 20 25 30 35 40 45 50

Inflation—Hedging it & Trading it Deutsche Bank 5.2 Assessing Relative Value

5 Sources of Asset Swap Difference

5 Sources of Asset Swap Difference The difference between a nominal “Of these comparative measures… asset swap and a Linker Asset Swap richness is the true measure” PV01 difference of the same maturity is a function of – Stephane Salas, – Linkers have a higher duration the larger credit exposure, the term Global Head of Inflation Trading structure of credit and the swap Swap richness richness – The spread between inflation-linked swaps and implied bond break-evens For example gives rise to different asset swap 20 bps richness results in an additional levels for linkers and nominals 28 bps on asset swap – a 40% increase – It also usually tells the story of swap supply and demand… Fig. 1: Measures of Relative Value Seasonality Source: Deutsche Bank – See the section on page 3.4 Accounts Accounts for Adjusts for Fair Value Credit / Liquidity for Cashflow Term Structure Dirty Price Discounting – Mis-priced credit cost leading to Pattern of Credit ‘value’ for issuers Par par ASW

Net Proceeds Tax √ ASW – Favourable deferrals for issuers encourage supply Z spread √ √ ‘Richness’ √ √ √ √

Inflation—Hedging it & Trading it Deutsche Bank 5.3 Assessing Relative Value

What is the ‘Fair’ Price for Inflation Protection?

What is the ‘Fair’ Price for Inflation Risk Premium includes “The biggest mistake people make Protection? – Potential change in monetary policy with inflation-linked bonds is target (e.g. 4% plus or minus 1% thinking that the breakeven inflation Inflation ‘Breakeven’ is not equal to instead of under 2%) is the market’s expected inflation market inflation expectations but is a – Abandonment of monetary policy rate. It is not and should not be. factor of in favour of employment or The breakeven includes what the – Inflation expectations currency board market expects inflation to be – ‘Risk Premium’ – EUR breakup, expansion or and the major portion of the risk – ‘Liquidity Premium’ succession premium that you should find in – Asymmetric elasticity of inflation: the nominal market, and the Inflation expectations over the very wages are easier to raise than to cut liquidity premium” long run are hard to judge but tend to – Markus Heider, be based on current economic policy Liquidity premium includes Global Head of Inflation Research – ECB target rate is ‘under, but close – Relative demand and supply for to 2%’ inflation bonds v nominal bonds – Balance sheet costs of holding inflation bonds to recycle inflation – Opportunity cost of capital for cash used to hedge inflation

Inflation—Hedging it & Trading it Deutsche Bank 5.4 Assessing Relative Value

Fair Credit Spread of Inflation Fig. 1: Fig. 2: Linked Bonds Linker as a Series of Forward Creating a synthetic 30-year old Issuing Linkers equates to borrowing Starting Bonds Nominal Bond more over time in nominal terms i.e. it Source: Deutsche Bank Source: Deutsche Bank Initial Principal Amount Fwd Borrowing Year 1 can be thought of as a set of forward Fwd Borrowing Year 2 Fwd Borrowing Year 3 Fwd Borrowing Year 4 Fwd Borrowing Year 5 Fwd Borrowing Year 6 Fwd Borrowing Year 7 starting bonds Fwd Borrowing Year 8 Fwd Borrowing Year 9 EUR 100mm 30y @ 150bp

140 Borrowed Amount

Forward starting bonds = greater 120 = credit risk 100 EUR 25mm 20y @ 130bp 80 EUR 25mm 10y @ 100bp 30y accreting @ 175bp Two components to fair price: 60 EUR 50mm – The issuer’s current credit spread for 40 the maturity of the bond 20 – Forward credit spreads for each of 0 Years 0 1 2 3 4 5 6 7 8 9 10 the forward starting borrowings i.e. forward credit spreads A simple point, but investors may not recognise and price this correctly

Inflation—Hedging it & Trading it Deutsche Bank 5.5 Assessing Relative Value

The Question is… Hedge with Bonds or Swaps The Bond Universe Traditionally, many investors have Value within the UK – for example primarily considered inflation-linked Figures 3 and 4 on the right depict the bonds to hedge exposure value that can be created by switching between similar maturity nominal and However, a more modern approach is: inflation linked bonds. Fig. 3: – Bonds can be cheaper or more PV Gain of UKTi27 over the UKT27 expensive than swaps Figure 2 below depicts the value in Source: Deutsche Bank Past performance is not a reliable indicator of future performance – Buy the cheapest asset switching between short and long Switch in – Hedge the inflation with swaps maturity linkers. Switch out 8 PV Gain (%) – Opportunistically switch

between assets In terms of trading capability, how does this work? 6

This also gives a lot more flexibility to We should always be free to switch 4

hedge the desired cash flows, since at between UK Bonds and UK Linkers

the long-end there are only relatively 2

few bonds outstanding (and liquidity 0

can be better as well) 01/10 03/10 05/10 07/10 09/10 11/10 01/11 03/11

Fig. 1: Fig. 2 : Fig. 4: Swap Inflation Price – Bond Inflation Price PV Gain of UKTi40 over the UKTi27 PV Gain of UKTi40 over the UKT40 Source: Deutsche Bank Source: Deutsche Bank Source: Deutsche Bank Past performance is not a reliable indicator of future performance Past performance is not a reliable indicator of future performance Past performance is not a reliable indicator of future performance UK Italy Switch in Switch in France (French CPI) Germany Switch out Switch out France (Euro CPI) 50 10 PV Gain (%) 10 PV Gain (%) 40 8 8 30 6 20 6

10 4 4 0 2 2 -10

-20 0 0 2010 2016 2021 2027 2032 2038 2043 2049 2054 2060 01/10 03/10 05/10 07/10 09/10 11/10 01/11 03/11 01/10 03/10 05/10 07/10 09/10 11/10 01/11 03/11

Inflation—Hedging it & Trading it Deutsche Bank 5.6 Assessing Relative Value

Summary

To sum up… – Given the displacement between – These displacements can be inflation and nominal markets, there assessed by a variety of metrics are opportunities for arbitrage – The value of switching is evident – Asset swap spreads on linkers from the incremental excess pickup represent a premium for credit that that is generated by selling the is hard to price, and when coupled costlier asset to buy the cheapest with demand/supply imbalances and asset from time to time higher duration, they offer a pickup – Used as a systematic strategy to nominals for the same underlying this can yield substantial returns issuer over medium term horizons – Switching between equivalent risk – These represent incredible sovereigns/supra sovereigns can opportunities for ‘asset-heavy’ often, driven by dynamics of the investors, and the markets will cross currency swaps market, likely normalize with time, hence provide additional yield pick-ups it is important to act quickly

“There isn’t one risk free curve, “…there are incredible opportunities there are 100, 150, 200… the key is for asset-heavy investors…it is when do you pick ‘the fruit’, when important to act quickly” is the bond cheap enough?” – Haroon Sana, – Daragh McDevitt, Global Head of Rates Sales Global Head of Inflation Structuring

Inflation—Hedging it & Trading it Deutsche Bank Inflation Options

Inflation Options Who are the major players in the options market? Option Products What are the trading opportunities? 6 Option Strategies Creating Optimal Hedges

Inflation—Hedging it & Trading it Deutsche Bank Contents 6.1 Inflation Options

A relatively new market, inflation Fig. 1: Fig. 2: options traded between Europe and London Options Volumes NY Options Volumes the US have doubled every year since Source: Tullett Prebon Source: Tullett Prebon 7,000 Volumes 1,800 Volumes trading started in inflation swaps in (millions) (millions) 6,000 1,600 2002/2003. 2010 saw a particular 1,400 5,000 1,200 growth spurt. 4,000 800 3,000 600 2,000 Long term growth looks set to 400 continue at this explosive rate, which 1,000 200 is clearly indicative of its importance 0 0 01/09 03/09 05/09 07/09 09/09 11/09 01/10 03/10 05/10 07/10 09/10 11/10 01/11 03/11 to clients and represents a substantial 01/09 03/09 05/09 07/09 09/09 11/09 01/10 03/10 05/10 07/10 09/10 11/10 01/11 03/11 opportunity to DB as intermediary between buyers and sellers of inflation.

Interbank volumes reached 50bn in 2010, up from 13bn in 2009, and just 1bn in 2005.

Inflation—Hedging it & Trading it Deutsche Bank 6.2 Inflation Options

The market is becoming more and more complex as sophisticated new Asset Manager players such as hedge funds, liability Monetize driven investors, and non-life insurance Embedded Floors practitioners are added to the mix.

Buy Deﬂation Hedge LPI Any client: Protection Liabilities – holding a bond portfolio Inﬂation Options – subject to tail inflation – high or low Insurance Company Pension Fund Market – who has revenues or liabilities that are indexed to inflation is exposed to inflation risk Directional/ Hedge LPI RV Trades Revenues

Hedge Fund Real Estate Investor

Inflation—Hedging it & Trading it Deutsche Bank 6.3 Inflation Options

Year on Year cap/floor Fig. 1: Fig. 3:

– YoY floorlet : Max [ K - YoYt , 0 ] 5y 0% YoY floor HICPxT Limited Price Index (LPI) Source: Deutsche Bank Source: Deutsche Bank – With YoYt = It/It-1 - 1 Past performance is not a reliable indicator of future performance

– A 5 year 0% YoY floor costs 80c 400 Price (bps) 6.0 %

350 or 18bp p.a. 5.0 – Demand from retail notes >> Supply 300 4.0 from premium sellers 250 200 3.0

150 2.0 Zero Coupon cap/floor 100 1.0 50 – ZC floor: Max [ (1+K)^t - tI /I0 , 0 ] – A 10 year 0% ZC floor costs 55c 0 0 – Supply from linkers and asset swaps 08/06 05/07 02/08 11/08 08/09 05/10 02/11 YoY Inﬂation -2% -1% 0% 1% 2% 3% 4% 5% 6% 7% >> Demand from deflation hedgers Fig. 2: Fig. 4: Limited Price Index (LPI) 10y 0% ZC floor HICPxT DB Inflation pages: DBII Source: Deutsche Bank – LPIt = LPIt-1 * { 1 + max [ min [ YoYt , Past performance is not a reliable indicator of future performance 5% ] , 0% ] } 160 – Inflation observed annually, collared, 140 compounded… and paid at maturity 120 100

– Demand from LDI funds >> Supply 80

from real estate investors 60

0 04/09 10/09 04/10 10/10 04/11

Inflation—Hedging it & Trading it Deutsche Bank 6.4 Inflation Options

LPI Collars represents a great inflation- Expert historical perspective Fig. 1: hedging alternative Markus Heider, responsible for Assumed Constant Year on Year Inflation risk for Pension funds and European inflation research at DB Inflation Return other liability-driven investors is big, Global Markets Research, provides Source: Deutsche Bank RPI ZC Swap 20 – 30% of scheme risk. a useful long term perspective: this 100% LPI Collar graph shows how the volatility we have 40 Payoﬀ Breakevens are deemed expensive: if, seen in the last three years is nothing 30 for example, breakeven is 3.7% and compared to the last 200 years. In the 20 the scheme expected inflation of 2.8%, long run, inflation is a very volatile 10 hedging loses value (figure 1). entity, which means risk and therefore, 0 -10 opportunity. 30y Breakeven What’s the solution? -20 3.63% Cover inflation risk by creating an -30 The relative stability we’ve seen in the -4% -3% -2% -1% 0% 1% 2% 3% 4% 5% 6% 7% 8% inflation collar last 20 years can very quickly change – Pay LPI Fig. 2: – Receive RPI Significant risk factors currently include Consumer price inflation, y/y%, 11-yr MA governments with unsustainable Source: EH Net “The catalyst that makes this trade deficits and globalisation; the need UK US

work is inflation at above 5% – this to hedge inflation risk is becoming 15 5% strike is currently lower than increasingly relevant 10 10 spot inflation – a change from the 2 8 1 4 6 last five years” 5 – Nicolas Tabardel, 0 9 Global Head of Inflation Volatility -5 and Exotics 3 5 7 -10 1750 1775 1800 1825 1850 1875 1900 1925 1950 1975 2000

1. US war of Independence 2. Napoleonic Wars deficit monetised 3. 1st Industrial Revolution: productivity-led deflation 4. US Civil War 5. 2nd Industrial Revolution: productivity rebounds; gold finds 6. Fiscal monetisation during WWI 7. Great Depression 8. Fiscal monetisation during WWII 9. Fiscal monetisation during Vietnam War; oil shocks 10. Volcker clamps down on inflation

Inflation—Hedging it & Trading it Deutsche Bank 6.4 Inflation Options

Market vs Economist Expectations In Europe, volatility is too high, tails are Fig. 1: UK RPI future inflation: the market too fat, and the skew is too steep. Skew prices floors higher than caps in the long term is pricing much Source: Deutsche Bank SPF prob distribution for 5y infl forecast more downside risk than upside What does this mean? Market Implied Probability from EUR YoY caps/floors

0.4 % risk. In the UK, the risks of inflation Selling volatility now is a good idea

overshooting are much higher than

The skew was pricing floors higher 0.3 them undershooting. This is contrary to

what we see in other markets. than caps; the skew is now symmetric 2 0.2 (figure 2).

In Europe and the US, there is more 0.1 3 1

balance; caps are becoming more 0 much more expensive than floors. “We expect this trend to continue, <0 0 - 0.5 1.0 - 1.5 2.0 - 2.5 3.0 - 3.5 >4 so that by the end of 2011, caps 1. Deflation risk is overpriced 2. Consensus economist predictions imply market implied volatility is too high Consensus economist predictions become more expensive than floors, 3. ‘Fat Tails’ indicate that market implied volatility better reflecting fundamentals” is too high; tails are too fat and the – Stephane Salas, Fig. 2: skew is too deep. Caps have no natural Global Head of Inflation Trading Ratio of market implied probability vs. supply in Europe or the US so the tail Economist Expectations risk is always expensive (figure 1). Source: Deutsche Bank 40

Value in selling ‘wings’ distribution i.e. far out of 30 the money caps and ﬂoor

0 <0 0 - 0.5 1.0 - 1.5 2.0 - 2.5 3.0 - 3.5 >4

Inflation—Hedging it & Trading it Deutsche Bank 6.5 Inflation Options

Collars (figure 1) Fig. 1: – Sell Floor Long (0,3) Collar – Buy Cap Source: Deutsche Bank 8 Payoﬀ (%) Strangles (figure 2) 6 – Sell OTM Floor 4 – Sell OTM Cap 2 0 Straddles -2 – Sell Floor and Cap at same strike -4 -6 YoY Inﬂation Print (%) -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 Range Accruals – Pays N/12 * Fixed Rate, Annual Fig. 2: – N = No. of months 1% < YoY EUR Short (0,3) Strangle HICP <3% Source: Deutsche Bank

– 5y Note with DB funding, Fixed 1 Payoﬀ (%)

Rate = 3.40% 0

-1

-2

-3

-4

-5 YoY Inﬂation Print (%) -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8

Inflation—Hedging it & Trading it Deutsche Bank 6.6 Inflation Options

Building Blocks Fig. 1: – Selling a 0% YoY floor Sell 0% floor, But 1x/2x Cap Spread – Selling a 1x / 2x cap spread Source: Deutsche Bank 3.0 Payoﬀ (%)

2.5

Premiums 1.5 – 5Y 0% floor generates 160bps 1.0 – 5Y 2% cap costs 260bps 0.5 – 5Y 5% cap costs 100bps 0.0 -0.5

-1.0 Using these components… -1.5 Zero cost and benefits from inflation YoY Inﬂation Print (%) -2 -1 0 1 2 3 4 5 6 7 8 9 10 between 2% and 8%

Covered Linker Switches – Sell nominal bond – Buy Linker – Sell year on year caps @ 2.5% on coupons and principal

OATei15 OATei22 OATei32

Covered Caps (%) (%) (%)

Upfront Premium 1.59% 3.95% 11.39%

Running Premium 0.40% 0.42% 0.73% (annual, 30/360)

Real Yield Pick-Up 0.32% 0.35% 0.43%

Effective Breakeven Rate for 1.25% 1.44% 2.67% outperformance of nominals

Inflation—Hedging it & Trading it Deutsche Bank Deflation Tail Risk 7 Deflation Tail Risk: DB 5 Year Note

Inflation—Hedging it & Trading it Deutsche Bank Contents 7.1 Deflation Tail Risk

Deflation tail risk: DB 5 Year Note

Deflation tail risk: DB 5 Year Note DB Short Deflation Risk Note – Reference Rates Investors can take advantage of the Indicative Trade Terms 5y Inflation B/E 1.735% substantial dislocations in the Inflation Indicatitive Terms 5y Swap Rate 2.16% Option Market by selling deep out of Max IRR 4.065% the money Inflation Floors. Currency EUR Format DB Funded Note A 5 year DB Deflation Note provides a return over 4% per annum if YoY Maturity 5 years Euro-zone Inflation prints above -2.0%, Issue Price 100.00 providing 190 bps of pick up over 5y EUR Swap Rates. Re-Offer 99.00 121 - Floor(T), minimum Redemption Euro-zone inflation printing below return of 0.00 -2.0% is an unprecedented event, never Where seen in ANY Euro economy. 121 * Sum[ Floor(t) ] for FLOOR(T) The below note details indicative t = 1,2,3,4,5 terms and compelling reasons for 12 * Max (Floor Strike - YoY Floor(t) investors to take on this risk for above Inflation, 0%) market returns. The last section looks Floor Strike -2.00% at variations in USD, GBP in addition to alternate ways of monetizing the CPI(t) / CPI(t-1) -1 Where CPI(t) is the EUR opportunity in EURs HICP ex Tobacco Index (CPTFEMU Index) 3m The underlying market dislocations YoY Inflation prior to Observation Date t are unsustainable and will soon be CPI(t-1) is the EUR HICP ex Tobacco Index (CPTFEMU removed by exogenous liquidity Index) 15m prior to provided by real money accounts. Observation Date t This opportunity represents clear value.

Inflation—Hedging it & Trading it Deutsche Bank 8 Case Study: Zero-Coupon Option Trade

Inflation—Hedging it & Trading it Deutsche Bank Contents 8.1 Case Study

Case Study: Zero-Coupon Option Trade

During the first six months of 2010, their views on the direction of inflation The transaction made perfect sense a Toronto-based insurer purchased by buying or selling zero-coupon for both participants. For the insurer, deflation protection worth $21.539 options. the 0% floors acted as a hedge against billion in notional, paying $173.7 million deflation and the impact that would in premium. The 10-year zero-coupon Daragh McDevitt, DB Global Head of have on its equity portfolio. At the 0% options were denominated in Inflation Structuring said, “It sparked same time, Pimco was able to cash in dollars, euros and sterling, and were interest because you have very on 0% inflation floors embedded in its executed by Deutsche Bank and Citi. intelligent investors on both sides who sizable portfolio of Treasury inflation- are taking opposite sides of the trade.” protected securities. The other side of the trade was largely taken by California-based fixed-income Since Q2, 2010, quantitative easing manager Pimco, which reported it had has encouraged more clients to sell sold more than $8 billion of 10-year implied inflation volatility at levels that zero-coupon 0% inflation floors in a look expensive. In particular, many filing dated August 27. The floors were market players have looked to play sold in return for more than $70 million inflation volatility versus interest rate in premium, with Deutsche and Citi as volatility – for example, by buying counterparties. interest rate caps and selling inflation caps at similar strikes. “We’ve seen a The transaction made perfect sense lot of clients coming in on the same for both participants. For the insurer, side as Pimco, viewing the probability the 0% floors acted as a hedge against of deflation priced in by these options deflation and the impact that would to be inflated. They are either selling have on its equity portfolio. At the the options embedded in their bond same time, Pimco was able to cash in portfolios, selling the options outright on 0% inflation floors embedded in its or entering into some kind of interest sizable portfolio of Treasury inflation- rate options strategy,” says McDevitt. protected securities (Tips). Dealers say the headlines generated by the trade had a positive impact on the market, encouraging other clients to express

Inflation—Hedging it & Trading it Deutsche Bank 9 Further Reading

Inflation—Hedging it & Trading it Deutsche Bank Contents 9.1 Further Reading