The European swaptions market is experiencing a severe crunch in implied volatility, as the rising cost of options and expected continued demand from pension funds looking to hedge fixed guaranteed annuities has created a one-way market with market-makers looking only to buy volatility in anticipation of more demand. In the last two weeks spreads on bids and offers--if they could even be found at the same time--were anywhere from five to seven times wider than normal, according to one market official, who also noted notional deal sizes have dropped by more than 50%. "There's a real dislocation of the market right now, a scramble to pick up vol," noted one head of interest-rate swaps in London, adding, "the number of people trying to sell is very limited." Vol for a 10 year option to enter a 20 year swap rose 10.61% Wednesday from 7.31% at the beginning of October, according to UBS Warburg.
Several factors have contributed to the rapid rise in vol, according to traders and analysts, who added that some firms may be caught short vol as a result of its ascension. Pension funds across Europe, especially those in Denmark, have been buying long-dated swaptions to hedge against their guaranteed annuity programs, and have ramped up their hedging in recent weeks as equity markets continue to sputter (DW, 10/22). That trend is yet to play itself out. Furthermore, some market analysts expect pension funds from other countries, such as the Netherlands and Switzerland, to follow the Danes and aggressively hedge their interest-rate exposure, despite the rising cost of options. "I don't think there's going to be any real let up in demand, because this has highlighted a potential problem for other people, and there's just not enough sellers," said Meyrick Chapman, derivatives strategist at UBS Warburg in London.
10 Year/20 Year Swaption Volatility
Source: UBS Warburg