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A Daily Fixing for the Inflation Swaps Market Société Générale Believes That the Market Is Now Ripe for Daily Inflation Swaps Fixing

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A Daily Fixing for the Inflation Swaps Market Société Générale Believes That the Market Is Now Ripe for Daily Inflation Swaps Fixing A daily fixing for the inflation swaps market Société Générale believes that the market is now ripe for daily inflation swaps fixing. This article reviews several formats for a fixing to quantify who would be the best candidate The eurozone inflation derivatives market has dramatically matured Prices quoted correspond to where each dealer would quote over the past five years as banks have actively been replicating the mid-market inflation swaps for a market size. many innovations from the interest rate derivatives world into the Rates reported by each dealer are made public for greater inflation derivatives world. The year of inflation-rate hybrids was transparency. 2006, while 2007 saw the arrival of inflation range-accrual products, The four highest and the four lowest submitted rates are despite the lack of liquid options and short-term futures markets eliminated, the fixing being calculated as the average of the that would allow banks to manage associated risks. remaining rates. These developments have generated ever-increasing activity in the zero-coupon inflation swaps market, with skyrocketing Second, for each currency, the timing of the inflation-swaps interbank volumes and tighter bid-ask spreads. However, many of fixing must be identical to the IRS ISDAFIX fixing. For instance, our clients are limiting their inflation activities to trading balance- the EUR inflation-swaps fixings should take place at 11:00am and sheet-consuming inflation-linked bonds. They choose to stay away 12:00pm Central European Time, while the GBP inflation-swaps from inflation swaps, as they find them less liquid and more difficult fixing should take place at 11:00am London time. This feature will to mark to market, despite wider availability of IT systems allowing make it possible to calculate a real rate fixing by combining the for proper management of these products. The perceived lack of IRS and inflation-swaps fixings. Unfortunately, today there is no transparency of inflation swaps pricing is definitely a hindrance to consensus regarding the type of fixing that should be contributed. the further development of our market. Four main questions have been raised by market participants: After discussions with eight major banks, it seems clear to us at Société Générale Corporate & Investment Banking (SG CIB) that the Year-on-year versus zero-coupon rate? market is now ripe for a daily inflation-swaps fixing – a small but Thanks to the consistency of payment schedule between year- significant innovation that would bring greater transparency and take on-year (YoY) inflation swaps and IRS, YoY rates could readily be our market one step closer to maturity, with tighter bid-ask spreads combined with IRS rates, which would make the value of YoY real and an eventual commensurate increase in participants and volumes. swap fixings easily available. However, inflation-swaps markets Today, such a fixing is possible as many banks seem willing have chosen the zero-coupon convention as it best matches the to commit to providing daily prices. It is not a question of ‘if’ but payment schedule of the underlying inflation-linked bonds and ‘when’ this new fixing will come to life, as inflation managers are still YoY inflation swaps are not liquid instruments. Moreover, there is debating what format such a fixing should take. This article details too much uncertainty surrounding the YoY convexity adjustment why we at SG CIB think that two consecutive monthly zero-coupon on long maturities, which makes YoY rates a poor candidate for a inflation-swap rates would be the best candidate for this fixing. fixing as the dispersion of prices provided by dealers would likely be greater. For these reasons, SG CIB favours contribution of zero- Proposed format coupon inflation-swaps rates. It is necessary to set up this fixing in a manner consistent with what exists today on interest rate swaps (IRS) so that it is accepted as a Interpolated versus monthly inflation indexes? benchmark by the entire marketplace. First, the daily fixing must be Market conventions on inflation swaps differ, with eurozone and UK transparent and calculated by an independent organisation. ISDAFIX®, Retail Price Index (RPI) swaps trading on a monthly fixing, whereas the benchmark for IRS fixings, provides the ideal framework for this: French and US inflation swaps trade on an interpolated basis. The International Swaps and Derivatives Association’s trading One could argue that each fixing definition should correspond practices committee selects banks on the basis of reputation with each market’s convention, but this would definitely create and expertise, reviews the composition of the panel of difficulties. For instance, combining two fixings in the form of a 10- contributors yearly and monitors the quality and consistency of year French versus 10-year European inflation spread, would require prices contributed. consistent reference indexes. 0907_Risk_SG_CIB.indd 82 30/8/07 17:09:39 SPONSORED STATEMENT Furthermore, swaps trading on a monthly fixing have the C. Pros (+) and cons (-) unfortunate tendency to display a price discontinuity at each Monthly (+) Interbank market convention on certain swaps month-end roll, as a difference between realised inflation and (+) Two consecutive monthly fixings allow for calculation of estimated seasonality will impact pricing. Inflation-swaps trading interpolated swaps on an interpolated basis smooths these seasonal effects over the (-) Not interbank market convention on all swaps entire month, thereby avoiding month-end jumps that could (-) Discrete jump at month-end due to seasonal roll jeopardise the success of this fixing. SG CIB favours contribution Interpolated (+) Interbank market convention on certain swaps of two zero-coupon inflation-swaps curves with a three-month Base index (+) Consistent with IRS fixings (+) No month-end jump as seasonality effect smoothed over month and two-month lag, which would allow for recalculating the (-) Not interbank market convention on all swaps interpolated zero-coupon inflation-swaps curve, and would also provide greater transparency on seasonality valuation. Zero-coupon (++) Interbank market convention on all inflation swaps (-) Payments are not synchronous with nominal IRS Real versus inflation rate? Year-on-year (+) Consistent with nominal IRS payment periodicity Payment Payment (-) Uncertainty regarding convexity adjustment periodicity Certain dealers argue that a zero-coupon real fixing rate would (--) Not a liquid market instrument be the most appropriate choice because it best matches pension Inflation (++) Liquid market instrument fund liabilities. It is our view that it is not necessary to directly Real (+) Matches pension fund’s liabilities publish such real rates, as they could be computed directly from Type the IRS and zero-coupon inflation-swaps fixings. Real rates are more (--) Not a liquid market instrument volatile than inflation rates as they tend to move with a high beta relative to nominal rates, which would add unnecessary fixing noise Short-term and long-term benefits on top of ISDAFIX IRS levels. We believe the immediate benefit of such a fixing will be to SG CIB favours an inflation fixing as most market participants attract more participants to the inflation derivatives market and (hedge funds, banks, some real-money investors) think today in to increase volumes and liquidity of zero-coupon inflation swaps. terms of inflation breakeven, rather than real rate. An inflation fixing As investors get a daily reference, they will feel more comfortable would be the most representative benchmark for our market. holding inflation derivatives as they will be able to better mark their inflation-swaps portfolios to market. The fixing will also be used What maturities should be contributed? for swap terminations and cash-settled swaptions. It will also make Each market has its specificities. The UK RPI market trades mostly it easier for dealers to benchmark the price of inflation derivative on long maturities up to 50-years, whereas the eurozone and transactions in order to guarantee best execution to clients. French markets are more active in the shorter end of the curve. It Although the fixing itself will not trigger development of more will be up to each contributor panel to specify which maturities exotic products such as inflation constant maturity swaps and are relevant to their market. On the eurozone and French inflation- inflation swaptions or their real rate counterparts, it will provide the swaps markets, SG CIB would be happy to provide daily fixings on proper setting and may act as a catalyst for increased client demand two consecutive months as shown in tables A and B, the example for these products. One could also imagine that the five-year or 10- given for the Harmonised Index of Consumer Prices (HICP) ex- year fixing be used as the underlying benchmark for new cash-settled tobacco fixing is as of 17 August 2007. futures contracts. These long-term inflation futures contracts could The arguments for and against a daily fixing are summarised in give users an exposure to inflation expectations, and would be more table C. volatile and quote with tighter bid/ask spreads than the existing short- term inflation futures. These contracts could, in turn, attract further participants and liquidity to our market, as people unable to deal in A. HICPxt inflation fixing B. HICPxt inflation fixing inflation swaps will be able to get an exposure to inflation through the May 07 June 07 futures market. Dealers could also eventually use such futures spreads Maturity Zero-coupon rate Maturity Zero-coupon rate to match and move forward, in time, their reset risk exposures. 1y 2.016% 1y 2.029% Let’s get our act together – when will it be done? 2y 2.016% 2y 2.029% It is our conviction that an ISDAFIX inflation fixing will help the 3y 2.099% 3y 2.109% inflation derivatives market bridge the gap with its big brother, 4y 2.149% 4y 2.157% the interest rate derivatives market.
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