Lehman Brothers and Credit Suisse First Boston are recommending clients buy long-dated swaption vol ahead of the upcoming U.S. Federal Open Markets Committee meeting. In the trade, the banks are recommending clients buy long-dated swaption straddles, whose value increases if long-dated swaption vol rises.
Mortgage servicers and investors are keen to hedge refinancing risk with swaptions as interest rates fall, meaning that long-dated swaption vol should rise over the next several months, said an official at CSFB in New York.
The traditional supply of swaption vol has been steadily decreasing over the last year, said George Oomman, chief interest-rate derivatives strategist at Lehman Brothers in New York. Agencies supply vol to dealers mainly via entering swaps with embedded options on the back of issuing callable notes. Over the past year, demand for callable notes has been decreasing due to high interest-rate volatility, and lower demand from banks, one of the larger investors in callables. This decreased supply in vol for dealers would point to intermediate- and longer-dated swaption vol rising.
Lehman is recommending a relative value trade in which investors sell short-dated swaption volatility, such as options to enter 10-year swaps in one year, and buy long-dated swaption vol, such as the option to enter a 10-year swap in five years. The trade is constructed with at-the-money swaption straddles, weighted in such a way as to make this a play on the slope of the vol curve, which at current levels is more inverted compared to historical levels, noted Oomman. Short-dated swaption vol should fall as the Fed's plans become clearer in the next several months, and the market is assuaged concerning the direction of interest rates. If the Fed cuts interest rates 50 basis points when it meets this week, the market should breathe a sigh of relief, and short-dated vol should fall more than longer-dated vol, he added.
CSFB recommends buying long-dated vol. The option to enter a five-year swap in five years had a premium of about 570 basis points at press time. At its peak this month, this level was 670bps, said the official at CSFB. During a similar turning point in the U.S. economy in 1994-1995, vol for a similar swap was nearly 700bps. This week's meeting might provide an instant lift to the position. If the Fed cuts rates by more or less than the expected 50bps, long-dated swaption vol could rise in reaction, he added. Even if the Fed cuts by 50 basis points, swaption vol could rise as mortgage players hedge. An offsetting factor here is the fact that following a Fed meeting, short-dated vol typically falls, sometimes dragging longer-dated vol down with it.
