Inflation traders in Europe are predicting a liquid market for options is just around the corner. The U.S. market leads Europe, with houses already pricing inflation caps and floors for institutional and corporate clients. The demand for inflation options in Europe is being led, in contrast, by retail interest in countries such as Italy and Spain. Officials said changes to pension fund regulations in Europe could bolster the underlying inflation swaps market over coming months which will also help develop a liquid options market. A poll by Barclays Capital at a recent inflation-linked conference found 27% of delegates likely to execute inflation derivative trades would use options and 22% would use caps and floors.
Joe Mulvey, inflation derivatives trader at Barclays in London, said the European market has become more competitive over the last 12 months and banks have begun to price a wider range of instruments. Italian and Spanish retail investors are buying inflation-linked medium-term notes structured with a floor. Banks selling inflation swaps to retail customers who want to buy the option to increase the size of the swap are using swaptions, reported traders. Hedge funds have also traded floors to take directional views on inflation, said Rashid Zuberi, co-head of interest rate derivative structuring at Deutsche Bank in London. However, "There's no observable volatility or correlation market," noted Mulvey, who explained this makes it harder to price.
Valdimar Armann, inflation derivatives structurer at ABN AMRO in London, says the U.K. inflation options market was one of the first to develop, helped by pension fund activity. Some U.K. pension funds have liabilities linked to Limited Price Indexation, which is inflation limited to 5% growth, and this creates demand for caps as well as floors on inflation. "We believe the options market will develop next year, but there needs to be more activity in the underlying swaps market in terms of more two-way flows," said Armann.
