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Interest Rate Cap Value and current volatilities environment

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The concept of volatility is essential in finance; from Value at Risk to derivatives pricing, it all relies to a significant degree on the level of volatility. During my first day on a trading floor more than a decade ago, someone quickly explained to me that implied volatility is the “...wrong number to put into the wrong formula to get the right price of plain vanilla options”[1]. This did not appear like a sound concept to me at the time. 

I later discovered that implied volatility is the market opinion or traders’ expectations of potential moves for a given asset (interest rate, FX currency pair, equity etc). It has no direction associated with the moves; a high implied volatility just means the market expects potential large changes in prices. Therefore, in a high volatility market, buying options is expensive. 

Low interest rates and large Quantitative Easing programmes have created a very low volatility environment across all financial markets. The VIX Index, also referred to as Wall Street’s ‘fear gauge’, which is based on the volatility implied by equity options currently trades close to historical lows.
 

Chart 1

Source: Bloomberg


Beyond equity markets, a look at interest rate volatility is also instructive. Below we have considered the example of a new interest rate financing with a 2-year mandatory hedging requirement. Firms will usually consider a swap or a cap for hedging the interest rate risk.

The graphs at the bottom (for USD, GBP and EUR) show the mid-premium of a 2Y ATM Cap expressed as % of the notional amount, repriced on a daily basis over two years (currently the fair value premium of a 2Y ATM cap in USD is c. 0.30% i.e. a mid premium of USD300k for a USD100m notional)

In mid-June, rates volatilities for all currencies reached exceptionally low levels vs the average over the last two years. For both EUR and GBP, option premiums are now back to their average (after two very volatile weeks), but for USD option premiums look still relatively attractive.
 

Chart 2_Interest rate cap

 

Chart 3_Interest rate cap

 

Chart 4_Interest rate cap

Source: SuperDerivatives/JCRA

This low volatility configuration is not exclusive to caps, but is also observable in swaption markets (option to enter into a swap at a future date). Swaptions will typically drive the price of vanilla pre-hedging situations (new financing or refinancing) and deal contingent interest rate hedges (cost efficient solutions to mitigate financial M&A Risks – so it is worth paying attention to this market.

So, at its comparatively low levels, is implied volatility fairly priced? It seems a bit paradoxical to observe such low volatility in an environment still characterised by high political and policy risk. This uncertainty does not seem to be fully reflected in current levels.  Reversing several years of excess liquidity is not a fast and straightforward process, but tapering should push volatilities higher again at some point.

 

[1] Rebonato, R. (2004) Volatility and Correlation: the Perfect Hedger and the Fox,2nd ed., Chichester, John Wiley & Sons Ltd.

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