Since well before the Mexican devaluation of 1994, investors and firms have had the ability to create or offset convex peso currency exposures using options. When it comes to interest rates, however, only recently have options become readily available, in the form of caps, floors and swaptions. Users now have the tools at hand to create or hedge contingent interest rate assets or liabilities denominated in Mexican pesos.
Peso interest rate options have been around since the late '90s, but only sporadically. A few U.S. banks were known to have sold a handful of interest rate caps to corporate clients during that period. There was no significant market until the middle of last year, however, when the interbank market began trading with some regularity. Activity has since steadily increased, with around 10 banks actively trading Mexican interest rate options. Between June and September the average volume in the brokered market was two or three trades per week, with an average trade of around MXN150 million (USD13 million) and a typical maturity of five years.
The standard reference for interbank interest rates in Mexico is the 28-day TIIE (Tasa de Interés Interbancario de Equilibrio) rate. Since there are approximately 13 periods of 28 days in one year, the one-year swap has 13 resets, and the one-year cap has 12 resets.
Trade Example: One-Year TIIE Cap.
Monday, Oct. 20; the one-year TIIE swap mid-rate is quoted at 6.6%. The one-year at-the-money-forward (ATMF) cap (6.60% strike) is offered at 0.51% of the Mexican peso notional amount, equivalent to an implied volatility of 28%.
ABC Corporation buys MXN500 million (USD45 million) of the ATMF cap at the offered price of 0.51% and pays a premium of [MXN500 million x 0.51%] = MXN2.55 million (USD230,000), payable on Oct. 21.
The first caplet reset occurs 28 days from the trade date, on Nov. 17. The 28-day TIIE rate on this first reset date is 7%. The cap seller pays to the cap buyer [7% - 6.60%] x [28 / 360] x [MXN500 million] = MXN155,555.56. This settlement amount is payable in arrears on Dec. 16 (i.e. T+29; since TIIE is a T+1 rate, the 28-day TIIE calculation period does not begin until Nov. 18).
If the date of the reset, Monday Nov. 17, is a Mexican holiday, the TIIE observation used would be the previous Mexican business day (e.g. Friday Nov. 14).
If the scheduled payment date of Dec. 16 is a Mexican holiday, the following day would be used, e.g. Dec. 17.
The second caplet reset occurs 28 days later on Dec. 15. The 12th and final caplet reset occurs on Sept. 20, 2004, with the final cap payout (if any) occurring on Oct. 19, 2004.
Interbank Trades
All interbank activity thus far has been concentrated in caps and receiver swaptions; no floors or payer swaptions have yet traded (most interest has been in strikes 100 basis points or more out of the money). This may be due to some "preferred habitat" phenomenon, whereby swap users tend to be concerned about falling rates and non-swap users tend to be concerned with rising rates. Unlike in the FX options market, to date there has been almost no interest in collar (or risk reversal) trades or buying a payer swaption while selling a receiver swaption.
The TIIE implied volatility curve is downward sloping with respect to maturity, similar to that for U.S. interest rate options. This is simply because short-term rates tend to be more volatile than long-term rates. The skew is somewhat similar to that for Mexican peso currency options, i.e. upside strikes (caps) trade at higher implied volatilities than at-the-money strikes, and downside strikes (floors) trade at lower implied volatilities than the at-the-money strikes, provided they are not too far out of the money on the downside.
A secular decline in the nominal level of Mexican interest rates over the last several years has fuelled greater corporate and investor interest. The rate on 28-day CETES (Certificados del Tesoro, or Treasury Certificates, i.e. Treasury bills) has declined to around 5% from almost 10% in March and 18% in early 2001.
Future Demand
The desire to lock in low nominal rates or protect portfolios from declining yields in an internationally disinflation environment should help to further the growth of the Mexican peso interest rate option market over the next year. In addition to the interest generated by such low yields, substantial growth in the domestic Mexican peso mortgage market should significantly increase demand for interest rate options, as banks look to hedge convexity generated by repayment options embedded in residential mortgages.
This week's Product Focus was written by James Kennan at BNP Paribas in New York.
