Mini Chapter Seven
Rate Option Strategies...Conditional Spread
- Conditional Spread strategies using rate options – now let’s look at option strategies on two different underlying i.e. curvature expressions where the payoff is conditional on a bullish or bearish interest rate environment. In other words these are conditional spread options that allow a more nuanced expression of a view as opposed to a plain steepener or flattener traded on an underlying swap spread. The strategy is usually DV01 neutral on both legs i.e. same as the underlying swap spread exposure in that regard.
- These spreads can have 4 different expressions: bull/bear flatteners and bull/bear steepeners. Much like bull/bear spreads that use calls/puts to structure them, a conditional bull spread uses receivers to express itself while a conditional bear spread uses payers. Leg-wise exposure to calls and puts can be understood from the table below:
Table 5. Conditional Spread Composition
| Strategy | Option Type | Front Leg | Back Leg |
|---|---|---|---|
| Bull Flattener | Receiver | Short | Long |
| Bull Steepener | Receiver | Long | Short |
| Bear Flattener | Payer | Long | Short |
| Bear Steepener | Payer | Short | Long |
Source: Pandemonium.
Motivation for initiating these strategies:
- Prime motivation as is true for any strategy is to be able to initiate it in the most cost effective manner. Big macro factors like changing central bank monetary and or QE policies, government fiscal dynamics, market-sensitive regulatory changes (BASEL/Accounting standard changes, IFRS implications for lifers’ et al), structured issuance dynamics (dealer gamma hedging) often generate more specific bull/bear views on curvature. Conditional spread strategies would be the way to express those views.
- The conditional aspect of the trade which reduces the probability of a payoff versus a vanilla swap spread trade and or a spread option (to be explained later) also makes it cheaper for instance entry levels are better for a zero PV conditional curve option.
- Or seen another way – a bull spread strategy structured with receivers limits the profit/loss scenarios to a rallying rates environment since in a sell-off the receivers are worthless. Similarly for a bear strategy structured with payers the profit/loss scenarios are limited to a rates-sell off environment.
- Relative implied volatility swings across tenors of the interest rate curve would typically help to cheapen the option spread. Vol of a specific tenor that’s (adequately) rich versus the others and its own history can help finance the long option leg of the spread. Furthermore, a strong bias to either receive or pay select tenors has the ability to create skews for OTM strikes for those tenors in the forward space, which if capitalised (i.e. selling these strikes) can enhance the spread entry levels.
- As an example let’s consider a recently popular bear strategy – 1y forward 2s10s USD SOFR conditional bear steepener i.e. going short a 1y forward 2y payer and long a 1y forward 10y payer. When we think about the rationale for this (or any other) trade, following template would generally come in handy (I’ll attempt to tie up every aspect with today’s market – Sep 6, 2023):
- Broad macro framework within which the trade is being structured – Consider the current US growth backdrop which has been surprisingly resilient after over 500bps of tightening over a span of barely 1.5 years, with a soft landing scenario a lot more likely than a hard landing/recession. This has also bought time for the US Fed to keep rates elevated (not rush into cuts), nudging the term premia in general higher. There’s also been an uptick in both government and corporate bond issuance amidst a bearish Global Fixed Income outlook (reinforced by BoJ raising its YCC target), that’s met with a buyers’ strike -> bear steepening on rates.
- Kinks and relative cheapness on spreads across the curve – Relentless flattening of the curve for most part of the hiking cycle has kept vols elevated for a 1y2y payer versus the back end (1y10y in this case). Trajectory of the ATMF and or ATMF + 25bps implied vol ratios for the two legs can be compared with its history to understand the relative cheapness/attractiveness of the skew of one leg versus the other.
- A zero cost structure is a better way to visualise the relative valuations – in the current market, premium on a 1y2y ATMF +25bps payer equals the premium on a 1y10y ATMF payer; strategy is DV01 neutral, hence a premium of 44cents for each leg would apply on different notionals). We would not get into the pricing methodology here as the intent is to intuitively make sense of the trade structure which offers a 25bps better entry level versus the ATMF spread.
- Compute the net carry on the trade – in other words what would be the change in premium over 3 months using the respective implied vols of the strikes, curve roll-down and time decay (that’s a function of vol term and curve carry among other things) after 3 months.
For starters this swap spread has a large negative roll if you notice the levels below, rolls 16bps negative over 3 months.
Spot 2s10s spread: -92bps
1y forward 2s10s ATMF spread: -24bps
9m forward 2s10s ATMF spread: -40bps
Table below gives a snapshot of the changing premium and implied vols for the respective legs over a 3 month period. We are short the implied vol on 1y2y that’s gone down a bit (is in our favor) and long implied vol on the 1y10y leg that’s barely changed much. As for the premium – the 9m2y has gained a bit given a 4.305 payer is less OTM/ closer to ATMF (at 4.25, versus 1y2y ATMF at 4.055) and 9m10y has suffered a time decay. Net premium is down to ~ -5cents (from flat earlier), mainly dragged down by the negative curve roll.
Table 6. Trade Snapshot
| Tenor | Levels | Spot Premium | Implied vol |
|---|---|---|---|
| Spot 2y | 4.9 | - | - |
| Spot 10y | 4.0 | - | - |
| 1y2y ATMF +25bps payer | 4.3 | 44.4 | 140.6 |
| 1y10y ATMF payer | 3.8 | 44.3 | 111.3 |
| 9m2y 4.305 payer | - | 45.3 | 138.4 |
| 9m10y 3.8 payer | - | 40.5 | 111.7 |
Source: Pandemonium.                      Â
*Spot premium in USD cents and Implied vol in basis points
- This trade expresses the recent bear steepening bias in the swaptions space and attempts to reduce the negative curve roll impact to the extent of the conditional curve delta (less than half of the underlying swap spread delta). But we need a strong bear steepening momentum for it to perform and more than offset the negative curve roll.
