Interest Rate Insurance Prices Implicit in Option Prices

of 5 Interest Rate Insurance Prices Implicit in Option Prices June 16, 2015 (#2015-13) Douglas T. Breeden William W. Priest Professor of Finance, Fuqua School of Business, Duke University and Senior Research Consultant, Amundi Smith Breeden 1 Rates increase globally as Eurozone and U.S. economies strengthen and deflation concerns abate. Option prices show increasing confidence in long-term normalization. I. Overview of Recent Events. The first half of June saw continued high volatility in global bond markets, especially in the first week. The 10-year German bund yield increased 33 basis points from 0.49% on May 29 th to 0.82% on June 15th. The U.S. 10-year rate increased 23 bp from 2.12% to 2.35%, and the U.K. 10-year Gilt increased 21 bp from 1.81% to 2.02%. Increases in rates were supported by strengthening retail sales and reduced deflation fears in Europe, as well as by a very strong job market in the USA. II. USA: Interest Rate Insurance Prices for USA LIBOR 3, 5, and 10 Years Out Seeing the much-improved job market, with unemployment claims running at very low levels and total job growth at very strong levels, Fed Chair Janet Yellen has said several times that she expects the U.S. economy to be strong enough to have liftoff in rates in 2015. Eurodollar futures markets appear to be betting that this will occur in September, rather than June 2015. Let s go to the prices for interest rate caps and floors (from Bloomberg) and see what the distributions are for the market s pricing per $1.00 of insurance for USA LIBOR. We will compare current pricing (yesterday s close, June 15, 2015) to March 6 th (immediately before ECB QE), and to May 29, 2015, two weeks ago. From Figure 1A, we see that the early June surge in rates globally brought the pricing of interest rate insurance for rates 3 years out back to the pricing before the ECB started QE. The mode is for 3-month LIBOR of about 2.00%, up considerably from the 0.29% rate today. Pricing is relatively symmetrical in the 3-year distribution, with roughly equal prices for 1.0% and 3.0% LIBOR scenarios. Prices for bets on LIBOR of 0.5% or less are likely dominated by fear of the likely bad economy if that happens (as well as probability of occurrence). As Figure 1B shows, these fears have diminished notably in the past two weeks. While the 5-year distribution remains bimodal, the pricing weights have shifted to more value being placed on the normalizing scenarios. This appears to be even more so in the 8-10 year prices (Figure 1C), as pricing for 3%, 4% and 5% scenarios have increased noticeably. With job growth quite rapid, labor market slack is being removed, and there are nascent signs of improving growth in real wages. Given the tightening labor market, most economists are now forecasting a pickup in real wage growth and in inflation. 1 I thank Rebekah Ackerman and Yue Teng of Amundi Smith Breeden for excellent research assistance.

of 5 Figures 1A-1C

of 5 III. Euro Area: Interest Rate Insurance Prices for Euribor 3, 5, nd 8-10 Years Out The insurance price graphs for Euribor, Figures 2A-2C, all show significant shifts in the past two weeks towards higher interest rates, reflecting the strengthening Eurozone economies, notably in Spain and France, but also in Germany and Italy. Deflation concerns are abating. As noted in the last letter, the ECB s QE policy has two potentially offsetting effects. First, there is the pure addition to the demand for long-term bonds, which pushes prices up and rates down. Secondly, and at least partially offsetting if not entirely reversing that effect, is that their goal is to stimulate higher growth through the way they implement this program. If they are successful, growth will be higher, future aggregate demand higher, and future inflation and interest rates higher. Figure 2A shows that for the 3-year Euribor rate, in the past two weeks we have seen a sharp move downward in pricing for the <0.5% rate scenario, and a sharp move upward in pricing for 1% Euribor. These moves appear to reflect increasing confidence that the Eurozone has turned the corner on growth and inflation. In Figures 2B and 2C, we see that in 5 years and 8-10 years, the prices for bets on Euribor of 2%, 3% and 4% have increased sharply in the past two weeks. And, as with the 3- year distribution, the pricing of the <0.5% recession scenario has diminished. Altogether, these moves show clear market bets moving towards ultimate economic normalization in the Eurozone. A number of factors likely are helping this develop, including (1) a lower Euro forex price, which helps competitiveness, (2) ECB QE stimulus, (3) structural employment changes in some countries, notably Spain, and (4) normal economic equilibrium adjustments. IV. U.K: Interest Rate Insurance Prices for Interbank Rates in 3, 5, and 8-10 Years The U.K. insurance price distributions in Figures 3A-3C show moves that are broadly similar to the moves in the Eurozone, but muted a bit, due to the weakness of some UK economic signals, as well as uncertainty about a possible Brexit vote. Prime Minister Cameron s promise of a vote in 2016 on staying in the European Union is causing anxiety in markets and possible uncertainty among business decision makers. However, in general, the UK economy has performed well in the past couple of years, stronger than other European economies. Housing prices continue to increase in the UK by 5% or so, year over year. As oil prices have bounced off their low levels and the unemployment rate is low at 5.5%, the stage is set for a possible buildup of inflation in coming years. Figures 2B and 2C show small, but notable increases in prices for interest rate insurance for interbank rates of 5%, 6% and 7% (rather high rates relative to a 2% inflation goal) in 5 to 10 years. Do note that the relationship of economic growth to inflation likely is a very nonlinear one that is shaped like an inverted U. Very low rates likely reflect very weak economies, as we saw in the recent Great Recession and Sovereign Debt Crisis. However, as in the 1970s and 1980s, very high rates of inflation can also be associated with poor economies. One would think that we are a long way from worrying much about that scenario, but it is a possibility, as is well known in many emerging markets. So, in terms of our insurance price distributions, we could see prices for very high rate scenarios (like 9%+) increase due to risk aversion and high marginal utility, as well as due to moves in probabilities.

of 5 Figures 2A-C

of 5 Figures 3A-3C