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.