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Encouraging Growth in the US Inflation Derivatives Market US INFLATION DERIVATIVES SPONSOREDSPONSORED ROUNDTABLE FORUM Risk: To what extent is the market for US inflation contingent on the asset swap market? To what extent does that have an impact and what other sources are out there when you look at it compared with Europe? Alvaro Mucida, JP Morgan: Asset swaps are still the major source of supply of inflation derivatives. One relatively new development in the market is that a broader base of clients is getting involved on the sell side, paying inflation. That includes real money, hedge funds and even insurance companies and pension funds, which historically had been exclusively receivers. The low real-yield environment also helps by bringing in people interested in paying real yields, which works effectively as supply of inflation derivatives. Then there are the traditional textbook sources of inflation derivatives such as infrastructure and utilities, but the Street hasn’t Encouraging growth in the been very successful in sourcing from them so far. There are a number of initiatives that are trying to get more infrastructure projects going in the US, like the creation of an infrastructure Evan Guppy development bank. That could be very positive for the future of US inflation derivatives market inflation derivatives, but it is still further down the road. Risk: Is there still some interest in deflation hedges? Prabhat Arora: A number of equity hedge funds and portfolio Prabhat Arora, Bank of America Merrill Lynch: We have seen real- managers have shown an interest in deflation protection this year. There continues to be uncertainty about the direction of US inflation, particularly given the money players pay inflation, especially when forward inflation gets The bulk of their portfolio gets hurt significantly if there is a realised latest attempts by the Federal Reserve to stimulate growth, known as Operation Twist. This to certain levels that are perceived to be too high. That’s something deflation scenario, so buying deflation floors is a good tail-risk new and it has also been a source of inflation supply for the Street protection strategy. Compared to some of the other options that uncertainty is encouraging a broader range of investors and hedgers to enter the US inflation in swap format. are available for tail-risk protection, deflation floors are still relatively derivatives market, according to senior inflation experts in a panel discussion sponsored by cheap because there is a decent supply of these through issuance Risk: Is anyone interested in inflation protection now? We’re still of Tips and subsequent asset swapping of these Tips. BGC Partners in New York recently in quite a low inflation environment. Evan Guppy: Headline consumer price index (CPI) is 3.9% in the US. Risk: What do you think of the way liquidity has developed in That still tends to grab people’s attention. For overseas investors – the market over the past year? Are dealers able to get large the overseas central banks, European banks, UK- or Asian-based transactions done? insurance companies or asset managers – one of the things they Nikolay Stoyanov, Barclays Capital: It’s probably back to pre-crisis are concerned about when investing in US markets is the strength levels of 2006 and 2007. There are two ways we can judge that. One of the currency. One easy way to mitigate risks against currency is by how much a large transaction will move the market, and it’s not depreciation is to buy inflation protection via the cash market, that much. Two, you have broker quotes basically – quoted by us, derivatives or options. In the past 18 months, we have seen people essentially – that are within a couple of basis points that nobody is who hadn’t looked at inflation before suddenly have inflation on hitting or lifting, which means that everybody is fairly certain where their radars. actual levels are. There is also another aspect to this. During the crisis, Risk: Let’s start with the question of how volumes in US the spread between Tips breakevens and inflation swaps widened inflation swaps have held up over the past year. What have The Panel Risk: Do you see a similar trend in client activity at Citi? dramatically. The primary reason was balance-sheet concerns. This volumes been like? Bank of America Merrill Lynch, Prabhat Arora, Vice-president, Andrew Henson, Citi: We’ve seen a few equity accounts come in. has largely decreased as a concern. If we look at Tips on asset swaps D’Arcy Miell, BGC Partners: Over this past year, we have seen Inflation Trading We hadn’t seen equity participants in the inflation options space versus their nominal counterparts, that spread is back to what it was considerable growth in the market – across swaps, asset swaps Barclays Capital, Nikolay Stoyanov, Director, Inflation Derivatives Trading before. A lot of them are hedging equity positions with long floors. at the pre-crisis level. There is still demand for asset swaps because and options, with volumes up 70–75% compared to last year. BNP Paribas, David Pereira, Vice-president, US Inflation Trading That, along with positioning for protection, is something new to the The majority of that growth is in options, with an increase in Citi, Andrew Henson, Inflation and Cash Tips Trader market and is really making the inflation options space much more the volume traded of around 200%. Elsewhere volumes are up Credit Suisse, Robert Tzucker, Inflation Derivatives Trader and Director liquid. We no longer have everybody wanting to sell floors – we around 50%. Deutsche Bank, Allan Levin, Head of Inflation Trading, North America actually have buyers of floors on the other side. There is also that HSBC, Evan Guppy, Director, Inflation Derivatives Trading much more uncertainty in the eurozone. Given that risk, we’ve seen Allan Levin, Deutsche Bank: The growth in volumes reflects JP Morgan, Alvaro Mucida, Executive Director, Head of US Inflation Derivatives euro accounts doing cross-currency trades where they look at our an increase in the number of participants in the market. A good inflation, realised inflation versus implied volatility, and it looks fairly BGC Partners, D’Arcy Miell, Global Head of Inflation Products number of our trades have been with clients who had not traded cheap on inflation long-term implied volatility versus euro volatility. inflation prior to 2011. risk embedded in their portfolios and taking advantage of some Robert Tzucker, Credit Suisse: Even if you believe that inflation David Pereira, BNP Paribas: The growth in the derivatives market market distortions. might be quite low for a little while, the range of possibilities and is also the resultant of the significant increase of activity we outcomes of inflation are quite wide. With central banks printing witnessed this past year in the cash market (Treasury Inflation- Evan Guppy, HSBC: What we have seen this year, probably across money to try to get out of their problems, there is tail risk to the Protected Securities – Tips). A lot of players have been looking most markets, is that investors are trading more from the point of upside. If we get into the Japan scenario, there is tail risk on the at and taking more interest in inflation and real rates in general, view of fear rather than greed. As a result, there are more people downside. There is a variety of views and that’s something that with the past 18 months’ volatility and the absolute level of who are looking at inflation because of quantitative easing and helps the inflation volatility market grow. At the same time, it helps real rates in particular. As a result, we got a natural increase in high headline rates of inflation and thinking this is something they inflation products because investors see inflation products as a bit inflation derivatives, with more accounts managing the inflationNOT need to be concerned about.FOR REPRODUCTIONlike insurance. Nikolay Stoyanov US INFLATION DERIVATIVES SPONSOREDSPONSORED ROUNDTABLE FORUM people are still chasing yield, so that keeps the market well supplied inflation protection as well. The second theme is with respect to have been quite active in the long end of the UK asset swaps with synthetic inflation payers. The new development is inflation forward trading. At the beginning of the year, volatile movements market. They have started to look at Tips and say, well, these options. The market was non-existent a few years back. Now, there is in gasoline and oil had a significant impact on spot-starting headline levels relative to nominals and relative to where the a fairly good agreement over option pricing. It is interesting because, inflation swap prices. It was recognised that forward trading was an UK asset swaps are trading are actually quite cheap. So we see in a less developed market, you would expect a large divergence effective way to trade the inflation markets without having to be more and more people getting involved in the US market and, in way-out-of-the-money strikes and, while they have the greatest concerned about short-term movements in commodities or even increasingly, it seems to be these guys in the UK looking for value divergence in terms of dealer pricing, there is still what I consider to seasonality. So it freed participants to focus on long-term inflation outside of their own market and looking for Tips on asset swaps as be a relatively tight agreement. prospects without worrying about short-term dislocations – which a way of picking up extra yield. made many participants much more comfortable in trading D’Arcy Miell: The interbank market has become far more liquid inflation derivatives. Nikolay Stoyanov: There have also been opportunities over the over the last year.
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