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USD Swaption volume Dec 2023

Dec highlight:

The most interesting USD swaption trade in Dec was the significant trading volume reported in the 10y20y point, amounting to $4.6mm in vega. This made Dec the second-highest month for 10y20y vega following only Aug, despite overall vega volume being muted in Dec. This spike in 10y20y activity follows the large 10y10y transactions that we highlighted in the Nov report, and we suspect it is driven by a continuation of the same theme, i.e., Bermudan callable bond position re-hedging.

Dec report:

As 2023 came to a close, both gamma and vega reported activity slowed down. On the gamma side, transactions totaling $900k of gamma were reported, down 7% from Nov. In vega, there was a total of $94mm of vega activity, flat to Nov. Both vega and gamma showed significant declines from the peak levels seen in Aug.

The vega heatmap highlights prominent trades in the 10y20y point, which was the third most actively traded point of the surface by vega after 10y10y and 1y10y. Notably, the reported trades at the 10y20y point amounted to $4.6mm in vega, almost double the monthly average of $2.6mm observed in the first eleven months of 2023.

This spike is likely caused by the rally in the long-end of the USD swap curve, where 10-year rates decreased by approximately 50bps over the course of Dec. As discussed in the Nov report, large moves in long-end USD swap rates impact the call probability of Bermudan callable bonds, which are some of the largest positions on many banks’ USD swaption books. The change in call probability is reflected by a change in risk representation on the books. For instance, if a position suddenly becomes very likely to be called tomorrow, it will no longer contribute to risk reports. Consequently, traders buy/sell swaptions in the market in order to keep their overall vega risk balanced.

Although 10y10y reported the highest vega for both Nov and Dec, we think 10y20y is the more interesting trade this month. The flurry of trades in 10y20y potentially signifies stress in the USD swaption market. The USD Bermudan callable trades typically have a final maturity of 30 years or longer, implying that the relevant vega risk points for these trades should also have cumulative maturities exceeding 30 years, such as 10y20y. However, these extremely long-dated vega points are relatively illiquid. Therefore, traders initially rebalance their risk using more liquid instruments like 10y10y and hold a spread position between 10y10y and 10y20y, hoping that the vol surface does not markedly change shape in the short-term. Traders may resort to hedging with the less liquid 10y20y point if their risks have changed by such a large amount that adding more to the 10y10y vs. 10y20y spread position would breach risk limits.

This seems to have played out over Nov and Dec. In Nov, 10y10y was the most active vega point by far, while 10y20y did not even rank among the top 20 active points (although 20y10y did appear at number 7). By Dec, 10y20y had become the third most active vega point, and other typically illiquid points like 5y30y, 15y20y, and 10y30y also appeared within the top 20. If traders are forced to transact on these illiquid points of the vol surface to keep within their risk limits, then we may see wild price swings as the amount of risk that needs to be replaced overwhelms the market.

Fortunately, long-end USD swap rates have reversed some of the rally since the end of Dec, so the pressure on the market should also decrease but it’s a development that we’re watching closely.

USD Swaption volume: Week of 2023-12-08

Weekly highlight:

On Tues 5 Dec, a large volume of transactions were reported in the 10y20y point, totaling $1.52mm of vega risk. This made it the highest reported vega day in the 10y20y point so far in 2023. The surge in 10y20y activity is potentially due to the ongoing rally in long-end USD swap rates. As a result, banks with large USD Bermudan callable bond positions on their books have been re-hedging their vega risk. (For more information on the background of the USD Bermudan callable bond market and the risk dynamics, please refer to Nov month-end report.)

Weekly report:

Last week’s transactions bucked the trend observed in Nov, where volumes in both vega and gamma were unimpressive. Specifically, approximately $28mm of vega risk was reported, which was the highest since the end of Oct. In terms of gamma, around $250k of risk was reported, making it the second most active week, trailing only the week when the US inflation report was released.

Looking at the swaption points contributing most to the total vega and gamma risk, we also found some interesting trades. Firstly, the vega heatmap shows that the 10y10y and 10y20y points were the most active, accounting for $5.4mm (20%) of the total $28mm vega reported. This is unusual as 1y10y tends to be the most active point for vega, with weekly average in 2023 higher than 10y10y and 10y20y combined.

The frantic trading in such long-dated swaption points can likely be attributed to the USD Bermudan callable bond positions currently held in many banks’ vol trading books. In short, when the long-end of the USD swap curve rallies, the likelihood of the USD Bermudan callable bonds being called increases, hence changing the vega profile of the banks’ books. In fact, on last Tues, long-end USD yields reached their lowest level since summer, and we saw on that day the highest daily report of 10y20y transactions since the start of 2023. (Please refer to the Nov month-end report for more information on the background of the USD Bermudan callable bond market and the risk dynamics.)

On the gamma side, there were a couple of noteworthy trades when looking at the individual swaption point contributions. The gamma heatmap shows that 1m10y was the most active gamma point by far. While it is not uncommon for 1m10y to be the most active point, its dominance to this extent is quite unusual. For example, around $50k gamma was reported for 1m10y compared to less than $20k for 3m10y, making the ratio between the two points 2.5. In comparison, the average ratio for the entire year of 2023 is less than 2. One possible explanation is that 1-month expiries transacted last week will just cover the Christmas and New Year holidays, prompting traders to sell these contracts to reduce their theta bills as year-end approaches. However, if the market still expects volatility in Jan and Feb next year, then there will be less selling pressure in 3-month expiries.

Another interesting trade involved $17k of gamma transactions reported in the 1m20y point, making it the third most actively traded gamma point of the week. Although not a huge amount, 1m20y is typically an illiquid point, so it is rare for more risk to be traded on this point than, for example, 1m30y. We also highlighted the 1m20y point in our report for the week of 2023-11-24 (see here), so we will continue to monitor it to determine if this marks the beginning of a longer-lasting trend.

USD Swaption volume Nov 2023

Nov highlight:

The most interesting USD swaption trade in Nov was the significant reported activity in the 10y10y point, totaling $7.7mm in vega. This volume is close to the previous highs achieved in Mar and Aug, despite overall swaptions volumes being lower in Nov. This activity might have been driven by the significant rally in long-end rates in Nov, leading banks to re-hedge their existing Bermudan callable bond portfolios.

Nov report:

Nov continued the downward trend in reported USD swaption volume since the peak in Aug. In vega, transactions totaling $96mm of vega were reported, down approximately 40% compared to Aug. In gamma, there was a total of $960k in gamma activity, down approximately 20% vs Aug.

Despite the muted volumes in Nov, we noticed an interesting trade when looking at the vega heatmap of the swaption surface. The heatmap shows that 10y10y was the most active vega point for the month, with $7.7mm vega reported, which is 50% more than the second most active point, 1y10y with $5mm vega reported. This is noteworthy since 1y10y is usually the most active point. For example, over the rest of 2023, the total vega reported in 1y10y is, on average, around 20% higher than 10y10y.

As mentioned at the start of this post, the surge in 10y10y activity is potentially caused by the significant rally in long-end USD swap rates during Nov, leading banks with large USD Bermudan callable bonds on their books to re-hedge their vega positions. It’s worth giving some background on Bermudan callable bonds as they are some of the largest positions on many banks’ USD swaption books.

A Bermudan callable bond is a bond that can be called, i.e. cancelled, by the issuer returning the principal amount to the investor on specific dates. Issuers are willing to pay higher coupons on Bermudan callable bonds compared to standard bond because, in theory, they provide optionality to the issuer. If interest rates decline, the issuer can call the bond and re-finance at a new and lower rate. If interest rates increase, the issuer keeps the bond and enjoys a low funding rate compared to the prevailing market. In practice, the banks usually monetize this optionality by selling volatility on interest rates through the USD swaption market.

During periods of low interest rates in the 2010s, many financial institutions in Asia sought assets to hedge their long-dated liabilities, such as pension or life-insurance liabilities. These assets needed to have certain characteristics: (1) long-dated maturity, usually greater than 15 years maturity, to match their liabilities, (2) safety or at least a high credit rating and (3) high-yield. International banks with highly-rated balance sheets issued long-dated Bermudan callable bonds to meet this demand, and it quickly became one of the most important trades in the USD structured notes market in the last decade.

Given that these trades were long-dated, with popular variations having a final maturity of 30 years if not called, many of them are still held on the issuers’ books. This is what we believe is driving the vega activity when long-end interest rates move violently as they did in Nov. Roughly speaking, when interest rates are rising, as they did in the first half of 2023, the issuer is less likely to call the bonds in the near future, making the optionality on rates more significant on the back end of the curve. To monetize this, the issuer would sell long-dated, vega-heavy swaptions. When interest rates are decreasing, as they did in Nov, the probability of calling the bonds in the near future increases again, and the amount of optionality in the far future decreases correspondingly, requiring dealers to buy back the swaptions they sold. Although the exact swaption points that a dealer needs to re-hedge depends on their specific portfolio, it’s likely that many will trade the most liquid 10y10y point as a proxy.

Finally, interest rates have continued to decline into Dec, so we expect more interesting action in USD swaptions in the coming weeks.

Breaking down the gamma activity by trading days, we observe a flurry of trades reported on the day before Thanksgiving, totaling $140k of gamma. This amount is surprisingly close to the trading activity recorded after the US inflation reading was released the week before.

Looking at the specific swaption points that contributed to the surge in gamma activity last week, we note an interesting difference compared to the previous week. During last week, the swaption points 1m10y, 1m30y, and 1m20y accounted for around 50% of the gamma risk. In contrast, trading after the US inflation report in the previous week was dominated by 3-month expiries. This difference could be driven by the fact that swap rates had been declining for five consecutive days leading up to last Wednesday, thereby increasing demand for shorter-dated protection before many market participants headed off for a long Thanksgiving weekend.

It's worth highlighting that 1m20y ranked high in terms of reported gamma, despite being a fairly illiquid point. As can be seen in the graph below, the last time 1m20y was reported in a comparable size was about one month ago, with sporadic trading in between. This may have an interesting connection to the vega side of the market, where 10y10y was the most actively traded point. Given that both 1m20y and 10y10y have a total maturity of around 20 years, this potentially indicates hedging in the market for 20-year Bermudan callable bonds.

Last week we saw the highest surge in USD swaption activity since the start of Nov 2023. Across all expiry-tenor pairs, there was almost $300k of gamma and $27mm of normal vega in trading activity reported, compared to an average of $150k gamma and $21mm vega in the first two weeks of Nov.

The big macro driver behind this was the US inflation report released on Tues, which saw the October reading fall more than expected to 3.2 per cent. This was also the first decline in four months, prompting long-end swap rates to fall by around 20bps by the end of the week.

As expected, most of USD swaption activity for the week was concentrated on the day of the inflation report. There was a three-fold spike in gamma trading activity, with $150k in gamma trades reported over all expiry-tenor pairs vs. a daily average of around $50k.

Looking at the breakdown of the expiry-tenor pairs making up this surge in activity, there are other interesting observations. The three swaption points 3m30y, 3m10y and 3m15y collectively make up more than 50% of both the gamma and vega reported on Tues. The fact that greater than 10y tenors dominated the activity can be explained by the fact that the longer-end of the swap curve reacted more violently to the inflation data than the shorter-end. In fact, the longer-end of the curve has been the most volatile since Q3 of this year as a less active Fed meant focus has shifted away from the front-end rate direction towards the supply-demand questions for the back-end. In terms of expiry, with so much activity focused on 3m expiries, it would suggest that there is demand in the market for protection against further rates volatility going into year-end and the start of 2024.

It seems like despite FX spot being one of the most liquid asset classes, when it comes to NDF, data is really not easy to come by. For valuation teams, risk managers and traders alike, NDF data that is currently available is often difficult to work with, either because they are indications only from IDB, or else are non tradeable or non-traded data. 

At PriceVault we have spent the last few months working on NDFs, and using real time reported data am excited to announce that we are working with clients to provide them with NDF tick data with both price and volume.

We are also currently working on a beta version which will let clients know if a trade was aggressive or passive - please reach out to us if you would like to find out more.

Below is a chart showing a small selection of the data that we have - USDKRW NDF, IMM date expiries only, with NDF tenors going from 7 days to 365 days, printed trades only. We can also provide the volumes traded at each price! 

We are excited about this new data service available to our clients - contact us if you want to have API access at info@pricevault.io

This is part 2 of our user guide to creating bespoke trades and datasets on PriceVault.

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Welcome to another big interesting trades post.

Today we want to highlight how bid offer spreads in EUR Libor swaps have come down over the last month. From a peak of 2.6bps bid offer in July down all the way to 1.8bps. We think this is an interesting dynamic during the summer period, especially as volumes have also come down over the same period. Perhaps the market is regaining some confidence in terms of liquidity and short term volatility.

What is also interesting to note is that the top swaptions trades for the last few weeks have been 5y-30y and 3y-30y receiver trades that printed. 30y spot still the popular place to play, but swaptions expiries have been focused on 3y and 5y space compared to longer swaption expiries being traded in July.

Month end July was a busy time for many of our clients. We look forward to adding more functionality that will help make IPV and risk jobs easier and smoother.

Top Trades by Vega: