As the path of interest rates in Europe becomes clearer, hedge funds are increasingly capitalising on range-bound markets by systematically selling rates volatility, according to a report by Risk.net, citing data from dealers.
The trend has become more pronounced following the European Central Bank’s recent rate cut.
At the start of the year, euro rates markets anticipated several cuts from the ECB. However, it wasn’t until 6 June that the central bank lowered its policy rate by 25 basis points to 3.75%. Since then, two-year rates have remained between 3.4% and 3.05%, with markets pricing in around two additional 25bp rate cuts by year-end.
In this relatively stable environment, hedge funds are increasingly engaging in swaptions straddle strategies, which involve selling at-the-money straddle positions, where funds sell both a receiver swaption and a payer swaption with identical strike prices, maturities and notionals, aiming to profit from minimal movement in underlying rates without taking a directional market view.
Swaptions traders note that selling risk premium in a systematic manner has become more attractive this year compared to previous years due to the range-bound nature of current rates. Most of these positions involve short-dated expiries, such as one-month options on 10-year interest rate swaps (1m10y). The delta risk is typically re-hedged periodically, with the expectation that underlying rates won’t move significantly enough to erode the premium earned.
The strategy is based on the notion that option prices generally exceed fair value in range-bound markets, allowing funds to collect premiums without extensive delta hedging. However, if there is a significant move that pushes rates beyond the strike of the swaption, the funds might experience short-term losses, though the short expiry mitigates long-term impact.
Additionally, some firms have started selling strangles without delta hedging, which involves two strike prices, further demonstrating confidence in the stability of rates.
The increased activity in this strategy is reflected in the market, with traders estimating a 20-30% year-on-year increase. Notably, 1m10y volatility has been trading more cheaply than 6m10y positions, highlighting expectations of higher long-term volatility versus the short term. This discrepancy is partly due to the systematic selling of one-month expiries.
