Credit Suisse First Boston last week reportedly bought EUR500 million (USD458 million, notional) of interest-rate floors with low strikes as a gamma bet on euro-zone rate cuts, according to London-based traders. Approximately EUR500 million of copycat trades were entered into by other firms. An interest-rate derivatives options trader at CSFB in London declined comment and press officers did not return calls. Traders said CSFB entered three and four-year floors with strikes at 2.5-3%. It is exceptional for firms to enter options with strikes as low as this and there was almost no volume in the trades before the Federal Reserve rate cut, according to a trader. The at-the-money strike on four-year euro options was 4% Thursday.
The trades were executed Wednesday and Thursday. The cutting of the fed funds rate to 2.5% Tuesday spurred proprietary desks in Europe to enter these trades as they realized that euro-zone rates could go below the 3.5- 3.75% levels, where most market makers have positions.
Meyrick Chapman, derivatives strategist at UBS Warburg in London, said that a four-year floor with a strike at 2.5% would have cost approximately 25 basis points Wednesday. If the European Central Bank cuts rates by 75bps over the next nine months the trade will be worth 62bps. He added that most professionals enter trades this far out of the money, hoping to be able to sell the options at a profit rather than with the intention of holding them to maturity. He declined comment on who was behind the trade.
The options give the purchaser the strike minus six-month Euribor. If Euribor drops to 2% and the strike is 3%, the purchaser will receive 1%. Six-month Euribor was 3.42% Thursday.
