San Francisco Fed on Extracting Market Expectations Information From Yield Curve Options

An oldie but goodie, first posted November 9, 2013:
From the Federal Reserve Bank of San Francisco:
FRBSF Economic Letter

Implied Rate Correlations and Policy Expectations

Certain financial instruments provide information on expectations of future interest rate movements. One relatively new instrument is yield curve options, which allow investors to take financial positions on a range of possible future interest rates. These options can shed light on the views of financial markets regarding future monetary policy at a time when short-term interest rates are near zero.

The term structure of interest rates—rates at the full range of maturities—is vitally important to investors, policymakers, and market observers. Financial market focus on the term structure, also known as the yield curve, is particularly intense now since it reflects the trajectory of economic recovery and prospects of a shift in Federal Reserve monetary policy to a less stimulative stance. One place to look for market views on these issues is interest-rate derivatives markets, where traders put money at risk by taking positions in instruments linked to interest-rate movements.

This Economic Letter describes implied correlations among interest rates, a set of indicators of market uncertainty about and exposure to the future slope of the yield curve based on interest-rate derivatives. Each rate correlation expresses the collective views of market participants on the future spread between two points on the term structure. As a market-based estimate of uncertainty about the future slope of the yield curve, implied rate correlations can shed light on what policy moves market participants expect the Fed to make.

Implied rate correlations are derived from the prices of swaptions and yield curve options. Swaptions lock in the right to pay or receive a stipulated fixed interest rate, known as the strike rate, in a swap when the option expires. Curve options pay off if the spread between two interest rates with different maturities is above or below a stipulated strike level on expiration. Combining the information in the prices of these types of options offers an implied view on whether short- and long-term rates will tend to move together.

Implied rate correlations are a relatively new instance of a well-established category of policy indicators: estimates of market expectations of future asset prices based on derivatives. Other examples include using forward interest rates to estimate future interest rates, and estimates of the probability distributions of future interest rates based on interest-rate option prices (see Jackwerth 1999).

Curve options and implied rate correlation

A curve option is a cap or floor on the spread between two constant maturity swap rates with different terms. Its payoff is determined by the difference between the option strike and the swap rate spread at the curve option’s expiration. An example is the 10-year minus 2-year curve option expiring in one year, or “1-year 2s-10s.” If such an option is struck at 250 basis points, that is 2.50 percentage points, it pays the owner 0.0001 times the notional underlying amount multiplied by the amount by which the spread between 2- and 10-year swap rates exceeded 250 basis points in one year, provided that number is positive. If the constant maturity swap spread were 275 basis points in one year and the notional amount were $1,000,000, the option writer would pay $2,500.

Curve options were first traded in the early 2000s. Participants included retail, corporate, and other investors selling yield curve volatility, and hedgers such as insurance companies. In the years preceding the financial crisis, hedge funds and others expressing views on the yield curve entered the market. Dealers are mainly large banks. They describe liquidity as good, in that prices are consistent across dealers, for options up to one year and for standard curve spreads such as the 10-year minus 2-year. 

Figure 1
Implied correlation and yield curve option value

Curve option prices express implied rate correlations, that is, market estimates of uncertainty about the future term spread. For example, the price of the 1-year 2s-10s option expresses the views of market participants on how the 2s-10s swap-rate spread will change over the next year. These implied rate correlations can be thought of as extending to the shape of the yield curve the notion of interest-rate implied volatility, which is the market estimate of the magnitude of rate fluctuations over an option’s life.

The interest-rate derivatives used to compute implied rate correlations are standard at-the-money swaptions on two points on the yield curve and a curve option on their spread with the same expiration. For example, a 1-year estimate of the implied rate correlation between the 2- and 10-year rates is computed from 1-year swaptions on the 2- and 10-year rates, and a 1-year 2s-10s curve option. As seen in Figure 1, for given swaption prices, a more expensive curve option corresponds to a lower implied rate correlation.

The implied rate correlation expresses how market participants expect the term structure to change. A correlation close to one means the market considers it likely that any changes in interest rates will be parallel, that is, the two rates in a term spread will change roughly equally. A low correlation indicates the market expects rates at different points on the term structure to change by different amounts....MORE

HT: The Big Picture