Implied volatility in both the interest rate and the dollar foreign exchange options markets plummeted last week after the Federal Reserve laid out its plans for managing the economic recovery via interest rates. Stan Jonas, managing director in the derivatives products group at broker Fimat USA in New York, said Alan Greenspan's statement, which accompanied the 25 basis point interest rate hike, "will end volatility as we know it." The interest rate decision and accompanying statements caused Deutsche Bank's Gamma Index, which measures the volatility of three-month interest rate swaptions to fall to 106bps, from 110bps, its lowest level in over a year, said an official.
The interest-rate options market had priced in the possibility of a 50bps hike so long volatility interest-rate players were hammered after the Fed decided to raise rates by 25bps, noted market participants.
The Fed has made it clear it aims to either hold rates steady or raise them by 25bps per meeting, explained Jonas, adding that this takes out a lot of the instability. The Fed has such sway over volatility that its actions cannot be ignored. "If God tells you the stock market will go up every day then options are worthless," he added.
Eric Hiller, chief rates strategist at Bank of America in Chicago, however, believes rates are not perfectly priced by the market and pointed to inflation as being an alternative source of volatility. The core consumer price index figures are next scheduled for release in the middle of this month and will be closely watched, he said. The Fed does not forsee growth in inflation and has attributed recent elevations in inflation data to "transitory factors."
