Euro Interest Rate Swap Options Volatility to Rise, ING Says

Volatility on options on two-year interest rate swaps in Europe will likely rise faster than those on longer maturities as investors speculate on when the country's central bank will stop raising rates, according to ING Bank NV.

Investor uncertainty on the timing and direction of next interest rate adjustment by the Federal Reserve will also increase swings in short term interest rate swap rates in the 13- nation euro zone region, said ING, the largest Dutch financial- services company.

Ambiguity on European interest rates going forward and on ``the actions of the Fed will impact volatility on the options on short-term term interest rate swaps,'' said Yiu Chung Cheung, rates derivative strategist at ING Bank NV in Amsterdam. Higher implied volatility will increase the cost, or premium, investors must pay for these options.

In a swap, two parties agree to exchange payments over a period of time. Typically, one party will agree to pay a fixed rate, while the other pays a rate that changes with a benchmark index or formula defined in the contract.

Swaptions, options on an interest rate swap, provide a way to hedge interest rate risk. For example, a company required to make variable interest rate payments faces the risk that rates rise, increasing its borrowing costs. The company could purchase a type of swaption that grants it the right to lock-in a fixed interest rate on its payments. If rates actually decline below the fixed rate, or so-called swaption strike price, the company would not exercise the option.

Swaption Trade Recommendation

ING expects the European Central Bank to lift rates by 0.25 percentage point in September to 4.25 percent, and predicts a peak in rates next year at 4.75 percent. The Fed will hold rates steady this year before increasing borrowing costs at the start of next year, the bank said.

ING advises clients to purchase one-year swaptions on two- year European interest rates swaps and to sell those with similar maturities on 20-year swaps.

The implied volatility on the one-year option on the 2-year swap, or 1y2y swaption, is 11.20 percent. Implied volatility on the one-year options on the 20-year swap, or 1y20y swaption, is 10.45 percent. Implied volatility gives an indication of traders' expectations for future interest rate swings.

The strategy Cheung recommends involves the purchase and sales of so-called swaption straddles, which is the simultaneous purchase of a put and call on a swap with the same strike price. A call grants the right to buy, or for interest rate swaps to pay a fixed-rate, and a put gives the right to sell, or pay a variable interest rate.

Central Bank Rates

Interest rate futures traders in Europe bet on at least one more increase in rates this year by the ECB. The implied rate on the three-month Euribor contract for December settlement was at 4.54 percent yesterday.

The contracts settle to the three-month inter-bank offered rate for the euro, which has averaged 16 basis points more than the ECB's benchmark rate since the currency's start in 1999.

The Fed will probably leave its benchmark borrowing costs unchanged at 5.25 percent this year, and cut rates by 0.25 percentage points sometime in the second-quarter 2008, according to the median forecast of economists in Bloomberg News surveys published June 8.

Federal funds futures prices yesterday showed an 18 percent chance the Fed will cut rates to 5 percent by the end of the year, compared with a 6 percent chance of a rate increase to 5.5 percent on June 14.

Swaption Volatility

Volatility on interest rates swaps has declined over the last few years mirroring declines in foreign exchange and equities fluctuations. More clarity by central banks in signaling interest rate changes has helped reduce volatility, said Cheung.

The implied volatility on the 1y2y swaption at 11.20 percent is up about one percentage point from 10.4 percent reached on May 25, the lowest since at least December 1998, when Bloomberg began compiling data. The so-called normalized, or basis point volatility, which adjusts for the interest rate struck on the swaption of 4.812 percent, is about 55 basis points. Basis point volatility signals the likely basis point change in swap rates over the next year.

Interest rate swaps with a two-year maturity in cash market trade at 4.694 percent.

The trade ING is recommending is structured so equivalent movements in implied volatility across maturities will affect each leg of the swaption trade in a similar fashion, Cheung said.

The implied volatility on 1y20y swaption at 10.45 percent is up about 0.75 percentage point from 9.7 percent set on April 13, the lowest since August 2001. The normalized volatility, given the 5.078 percent strike rate, is about 53 basis points.

Interest rate swaps with a 20-year maturity in cash market trade at 5.038 percent.

source:www.bloomberg.com