Deutsche Bank Research Global Rates Date Inflation 25 February 2015 Markus Heider Alex Li Strategist Research Analyst (+44) 20 754-52167 (+1) 212 250-5483 DB Inflation Volatility Report [email protected] [email protected] Inflation Volatility Update The rebound in oil prices since the end of January together with (in EUR) ECB 1. 3M realised 10Y CPI swap vol support and better economic data has allowed some modest recovery in 1.00% breakevens, which has benefitted caps and weighed on floor premia over the CPXTEMU 3M Realised 10Y CPI swap vol past month or so. As a result, EUR 0% ZC floor implied deflation probabilities 0.90% USCPI UKRPI have retraced from the highs (of over 25% in 5Y, over 10% in 10Y) seen in early 0.80% January (chart 3). Levels remain above the averages seen in recent years 0.70% however (p. 6). 0.60% The fluctuations in crude oil prices are also an important factor behind the pick- 0.50% up in realized inflation swap volatility (chart 1), and together with central bank 0.40% news behind the rise in FX and nominal rates market implied volatility. In that 0.30% context, implied inflation vol has stabilized or moved slightly higher since the 0.20% end of last year; implied vol is typically above 3m averages (chart 2). 0.10% Jan-10 Sep-10 May-11 Jan-12 Sep-12 May-13 Jan-14 Sep-14 Trends between cap and floor vol have been diverging in recent months, both in USD and EUR, at least when looking at 4% and 0% strikes (charts 4 & 5). Source: Deutsche Bank Implied vol has risen noticeably for the former, while only recovering marginally for the latter. In USD, as well as for 5Y EUR, this may have been partly offsetting previous relative underperformance of caps, and divergence 2. Implied CPI vol, 3m z-scores seems to have stopped over the past couple of weeks. On the basis of the 3.5 year history shown in charts 4 and 5, RV gaps are largest in 5Y USD and 10Y 1.0 ZC options, implied volatility, 3m z-scores EUR, with in both cases 4% caps looking somewhat rich relative to 0% floors. USD 0.8 EUR 4. USD: cap v floor implied volatility 0.6 0.4 USD 5Y 4% ZC cap implied vol USD 10Y 4% ZC cap implied vol 5.0% 6.5% 0.2 USD 5Y 0% ZC floor implied vol USD 10Y 0% ZC floor implied vol 4.5% 6.0% 0.0 5.5% -0.2 4.0% 5.0% -0.4 3.5% 5Y 0% floor 10Y 0% floor 5Y 4% cap 10Y 4% cap 4.5% 3.0% 4.0% Source: Deutsche Bank 2.5% 3.5% 2.0% 3.0% Oct-11 Apr-12 Oct-12 Apr-13 Oct-13 Apr-14 Oct-14 Oct-11 Apr-12 Oct-12 Apr-13 Oct-13 Apr-14 Oct-14 3. Floor implied deflation probability Source: Deutsche Bank 5Y 10Y 25% 5. EUR: cap v floor implied volatility spot 1M ago 20% EUR 10Y 4% ZC cap implied vol 5.0% EUR 5Y 4% ZC cap implied vol 4.3% 7.5% 6.0% 15% EUR 10Y 0% ZC floor implied vol EUR 5Y 0% ZC floor implied vol 7.0% 5.5% 3.8% 4.5% 6.5% 10% 5.0% 3.3% 6.0% 4.0% 5.5% 4.5% 5% 2.8% 3.5% 5.0% 4.0% 2.3% 0% 4.5% 3.5% USD EUR GBP USD EUR GBP 3.0% 4.0% 1.8% 3.0% 3.5% 2.5% 1.3% 3.0% 2.5% Source: Deutsche Bank 2.0% 0.8% 2.5% 2.0% Oct-11 Apr-12 Oct-12 Apr-13 Oct-13 Apr-14 Oct-14 Oct-11 Apr-12 Oct-12 Apr-13 Oct-13 Apr-14 Oct-14 Source: Deutsche Bank ________________________________________________________________________________________________________________ Deutsche Bank AG/London DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P) 148/04/2014. 25 February 2015 DB Inflation Volatility Report: Inflation Volatility Update Covered call strategies, USD Breakeven1 ZC swap ZC swap plus short ZC cap ZC swap plus short YY cap 1 Tenor 4% ZC 5%ZC 6%ZC 4%YY 5%YY 6%YY 2y 1.28 1.27 1.28 1.28 1.25 1.27 1.28 5y 1.68 1.66 1.67 1.67 1.59 1.63 1.65 10y 1.98 1.95 1.97 1.98 1.86 1.91 1.93 1y z-scores for discount 2 Tenor 4% ZC 5%ZC 6%ZC 4%YY 5%YY 6%YY 2y 0.7 1.3 1.5 0.8 0.2 1.0 5y -1.0 -0.8 -0.6 -0.9 -1.1 -1.3 10y -1.4 -1.3 -1.4 -1.0 -1.0 -1.0 Source: Deutsche Bank Covered call strategies, EUR Breakeven ZC swap ZC swap plus short ZC cap ZC swap plus short YY cap 1 Tenor 4% ZC 5%ZC 6%ZC 4%YY 5%YY 6%YY 2y 0.16 0.16 0.16 0.16 0.15 0.16 0.16 5y 0.72 0.71 0.72 0.72 0.66 0.68 0.70 10y 1.15 1.14 1.14 1.15 1.03 1.06 1.10 1y z-scores for discount2 Tenor 4% ZC 5%ZC 6%ZC 4%YY 5%YY 6%YY 2y -0.1 -0.3 -3.3 0.1 0.0 -0.4 5y -0.4 -0.3 -0.3 -0.1 -0.1 -0.1 10y -1.6 -1.6 -1.5 -0.1 0.0 -0.2 Source: Deutsche Bank 1 Breakeven of the strategy if the YY cap is not exercised. 2 1y z-score of the difference between the ZC swap rate and breakeven of the combined strategy. Negative z-score implies that the strategy is less attractive at current levels relative to average and vice-versa Covered Call Strategies: Covered-call (CC) strategies in inflation markets can be implemented by being long CPI swaps (or ILB breakevens) and selling CPI caps. This strategy gains from the premium provided by selling the cap, while giving up some of the upside if inflation is higher than the strike of the cap (payoff profile shown on p. 2). The breakeven of the covered call strategy is lower than the B/E on the underlying swap and this ‘discount’ rises with the premium of the cap. CCs allow investors who are long inflation to monetize any potential richness in CPI cap markets. The tables above show current ZC swap rates for 2Y, 5Y and 10Y tenors as well as the breakeven levels of CC strategies for various cap strikes. While the discount is larger for lower strikes, implied volatility tends to be richer on high strikes. The discount achieved is higher when selling YY caps, but in that case the option payoff profile is not aligned with the underlying ZC swap, and the B/E levels shown in the table assume that none of the caplets is exercised. The tables also show the 1Y z-scores of the discount achieved by the CC strategy, putting valuations into historical context. A positive number indicates an above-average discount, i.e. that the CC strategy is currently more attractive than on average over the past year. Page 2 Deutsche Bank AG/London 25 February 2015 DB Inflation Volatility Report: Inflation Volatility Update Covered Call payoff profile Long swap + short collar payoff profile 25 Covered Call 20 'Collar' strategy upperbound 20 Short ZC cap Short ZC cap 15 15 Long ZC Swap Long ZC Swap 10 10 Long ZC Floor 5 5 0 -2.0% 0.0% 2.0% 4.0% 6.0% -5 0 -2.0% 0.0% 2.0% 4.0% 6.0% -10 -5 -15 breakeven of strategy -20 -10 breakeven of strategy -25 -15 -30 -20 Source: Deutsche Bank Source: Deutsche Bank Deutsche Bank AG/London Page 3 25 February 2015 DB Inflation Volatility Report: Inflation Volatility Update Long swap, short collar strategies, USD Breakeven ZC swap ZC swap, 0% floor, short cap ZC swap, -1%% floor, short cap Tenor 4% ZC 5%ZC 6%ZC 4% ZC 5% ZC 6% ZC 2y 1.28 5y 1.67 1.66 10y 1.98 1.98 1.98 UpperBound 3 Tenor 4% ZC 5%ZC 6%ZC 4% ZC 5% ZC 6% ZC 2y 5y 4.01 10y 4.01 4.02 Source: Deutsche Bank Long swap, short collar strategies, EUR Breakeven ZC swap ZC swap, 0% floor, short cap ZC swap, -1%% floor, short cap Tenor 4% ZC 5%ZC 6%ZC 4%ZC 5% ZC 6% ZC 2y 0.16 5y 0.72 10y 1.16 UpperBound 3 Tenor 4% ZC 5%ZC 6%ZC 4% ZC 5% ZC 6% ZC 2y 5y 10y Source: Deutsche Bank 3 Updu perBound level indicates the annualized inflation until maturity until which the collar strategy provides a better payoff than the simple long swap B/E strategy ‘Collar’ Strategies: Being long CPI swaps (or ILB breakevens) and short a CPI collar (by selling CPI caps and buying CPI floors) is a strategy that includes an additional leg over the covered call strategy to also provide downside protection while giving up some of the upside (payoff profiles for covered call and collar strategies shown on p. 2). The breakeven of this strategy is lower than the B/E of the underlying swap if the cap premium is higher than the floor premium.