Interest Rate Insurance Prices Implicit in Option Prices

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November 2, 2015 (#2015-18) Interest Rate Insurance Prices Implicit in Option Prices

Douglas T. Breeden

William W. Priest Professor of Finance, Fuqua School of Business, Duke University and Senior Research Consultant, Amundi Smith Breeden1

September-October 2015: Volatility subsides, stock prices gain globally. China finds support, while Europe, USA are solid. Rates increase after Fed indicates possible December liftoff.

I. Overview of Recent Events.

This note covers both September and October, as a month ago I did not write, as I was fortunate to travel and speak to central banks of France and Italy about this research, having already spoken to the Bank of England in April.

In September and October, stock markets rebounded around the globe, as all 17 Trillion Dollar Economies had gains, as shown in Table 1. The average stock price gain was 4.8%.

Table 1

1 I thank Rebekah Ackerman and Yue Teng of Amundi Smith Breeden, and Chloe Peng of Duke, for excellent research assistance.

Global Stock Market Valuation: 17 Trillion Dollar GDP Economies

Bloomberg Data with Prices as of Friday close, October 30, 2015

30-Oct-15 1-Sep-15 Last 12mo 2016 Last 12mo 2016 Return Return %PriceChg 52 Week

Price Price EPS LTM EPS Fcst P/E LTM P/E Fcst 1 Year YTD 9/1-10/30/15 High Off High Americas

United States 2,079 1,914 111.9 130.9 18.6 15.9 5.3% 2.8% 8.6% 2,135 -2.6%

Canada 13,529 13,482 678.3 956.1 19.9 14.2 -4.6% -5.2% 0.3% 15,685 -13.7%

Brazil 45,869 45,477 1416.1 4574.0 32.4 10.0 -16.0% -8.3% 0.9% 62,305 -26.4%

Mexico 44,543 42,912 1420.8 2545.0 31.4 17.5 0.8% 4.9% 3.8% 46,554 -4.3%

Europe

Germany 10,850 10,016 547.3 874.9 19.8 12.4 16.5% 10.8% 8.3% 12,391 -12.4%

France 4,898 4,541 218.6 344.2 22.4 14.2 19.5% 17.9% 7.9% 5,284 -7.3%

United Kingdom 6,361 6,059 242.9 454.4 26.2 14.0 1.1% 0.3% 5.0% 7,123 -10.7%

Italy 22,443 21,451 -83.4 1589.5 NM 14.1 16.6% 21.1% 4.6% 24,157 -7.1%

Spain 10,361 9,993 553.6 779.3 18.7 13.3 2.8% 3.8% 3.7% 11,885 -12.8%

Russia 846 805 101.3 156.9 8.3 5.4 -18.5% 11.7% 5.0% 1,280 -33.9%

Turkey 78,536 73,570 6605.7 9005.2 11.9 8.7 0.6% -6.0% 6.8% 91,806 -14.5%

Asia/Pacific

Japan 19,083 18,166 984.9 1163.4 19.4 16.4 17.9% 10.9% 5.0% 20,953 -8.9%

Australia 5,289 5,096 274.3 374.3 19.3 14.1 1.7% 2.7% 3.8% 5,997 -11.8%

South Korea 2,029 1,914 116.4 186.2 17.4 10.9 4.8% 6.1% 6.0% 2,190 -7.3%

China 3,383 3,167 191.2 270.5 17.7 12.5 41.3% 6.1% 6.8% 5,178 -34.7%

India 26,657 25,696 1287.4 1939.5 20.7 13.7 -2.9% 2.5% 3.7% 30,025 -11.2%

Indonesia 4,455 4,412 183.2 354.8 24.3 12.6 -10.8% -13.3% 1.0% 5,524 -19.3%

Averages 20.5 12.9 4.5% 4.0% 4.8% -14.1%

10-Year TreasYld 2.14 2.17

VIX 15.1 31.4

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Reflecting the subsiding panic from what happened in August with the sharp fall of stocks in China, the VIX volatility index dropped from 31.4% on September 1 to 15.1% on Friday, October 30th. During the past two months, interest rates first dropped significantly given the Fed’s holding rates at zero in September, with the U.S. 10-year rate dropping from 2.17% on September 1 to 1.99% on October 14th. However, in its October meeting on October 28th, while holding at zero for now, the Fed indicated that it was seriously considering increasing rates in December (which would add credibility to Fed Chair Yellen’s many statements that she expected liftoff in 2015). From Tuesday to Friday of last week, the US 10-year rate increased 9 bp from 2.05% to 2.14%, while the German bund increased 8 bp from 44 bp to 52 bp, and the UK 10- year Gilt increased the most (16 basis points), from 1.76% to 1.92%. Thus, markets are beginning to reflect expectations of liftoff. Stocks were unfazed by this (indeed, they seem cheered), as investors appear generally well prepared and appear to take it as a positive signal of economic strength for the Fed to prepare to finally raise rates.

II. USA: Interest Rate Insurance Prices for USA LIBOR 3, 5, and 10 Years Out Using cap and floor prices from Bloomberg Financial Markets and the technique of Breeden and Litzenberger (1978, 2014), we see in Figures 1A-1C the prices for interest rate insurance for 3-month LIBOR rates in 3, 5 and 8-10 years. The 3-year distribution moved as one would expect, towards higher rates in 3 years, given the Fed’s liftoff signal. I find the 5-year insurance price distribution to be more interesting and perhaps surprising. Prices actually increased for the fear scenario, i.e., for rates at the very low level of 0.5% or less in 5 years. Markets appear to be viewing the liftoff as having some risk that the economies will not handle it well, and we could be back in a recession or weaker economy in 5 years, causing rates to be taken back to zero. Or at least some investors wish to hedge that chance. However, note that the 8-10 year distribution really did not move last week with the Fed’s announcement. It continues to be highly bimodal, with big money bet on normalization over the long term, as well as money big money paid for insurance against the downside, and not much in between.

III. Euro Area: Interest Rate Insurance Prices for Euribor 3, 5, nd 8-10 Years Out Figures 2A-2C give the options markets’ pricing of insurance payoffs on Euribor in 3, 5, and 8-10 years, respectively. The insurance price distributions for Euribor did not change much in the past week. Changes that did occur were in the direction of higher insurance prices for the higher rate scenarios, presumably reflecting the need for Euro rates to compete with the presumably higher dollar rates. Data for European economies that is arriving is decent, so the markets appear to be betting a bit more on the normalization scenarios for Euribor.

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Figures 1A-1C

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Figures 2A-3C

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IV. U.K: Interest Rate Insurance Prices for Interbank Rates in 3, 5, and 8-10 Years

Figures 3A-3C give the insurance price distributions for the UK interbank interest rate 3, 5 and 8-10 years out. Among the 3 markets we review in this letter, the UK economy has performed the strongest, with the USA next and the Eurozone improving, but third strongest. It is interesting to see that the largest response (or at least correlation) was with UK insurance prices moving towards sharply higher rates, given the Fed’s liftoff signal. As the UK economy is doing well, perhaps one of the largest risks is possible weakness in the US and other major economies, such as in the Eurozone, China and other emerging markets. If the Fed believes enough that the US economy can handle rate increases, then investors probably read that as a sign of strength. And with the Eurozone also showing relative improvement, interest rates increased rather sharply in the UK, with the 10-year going from 1.76% to 1.92%, as noted. In Figure 3A, one sees that the pricing of the fear scenario of zero rates dropped quite sharply for the UK in the past week. In contrast, there were nontrivial increases in prices for 2% and 3%

interbank rates in 3 years.

Figure 3A

Similarly, the 5-year insurance price distribution for the UK also showed a significant drop in insurance prices for the fear scenario, and significant increases in prices for

normalization scenarios. Consistent with this theme, the long-term, 8-10 year distribution also moved in the direction of higher, normalized rates for the UK and a lower price paid to hedge the fear scenario.

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Figure 3B

Figure 3C

Sources: Bloomberg and Amundi Smith Breeden Analytics.

This information is taken, in part, from external sources. We believe these external sources to be reliable but no warranty is made as to accuracy.

This information is provided for informational purposes only and should not be considered a recommendation to buy or sell securities or a guarantee of future results. No assurance can be made that profits will be achieved or that substantial losses will not be incurred. All investments involve risk including the loss of principal.

No part of this presentation may be reproduced in any form, or referred to in any other written materials, without the written permission of the author.

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