Article: Swaptions Spotlight

31 October 2014 | Orlando Almodovar

Market Size

As the first swaptions clearing service prepares to launch by CME as early as November 2014, this data driven analysis of these instruments is timely to survey the market. 

Swaptions compose 5.6% ($31.7T) of the $564.7T interest rates swap market, and 24.9% of the uncleared market in gross notional outstanding.  

80% of the outstanding notional is evenly split in EUR & USD at $12.7T each, with 68% of USD swaptions underlying tenors maturing by end of 2016, compared to 37% for EUR.  In terms of number of contracts, 47% of the 90K USD contracts mature by end of 2016, relative to 32% of the 82K EUR contracts.  These shorter maturity tails reflect a benchmark for open interest eligible for the new clearing service.

CFTC data displays 65.4% of swaptions notional outstanding is market facing, and DTCC data shows 48.4% is dealer to non-dealer.

Volume & Transactions

Exhibit 1 lists daily swaption volume of new trades over 50 days from August 18th to October 24th, where average daily activity in swaptions is $36B, compared to $558B for all new trade rate swaps, and over $127B in the uncleared segment.  63% of swaptions volume is in USD, with 15% in EUR, and similarly trade counts for USD and EUR comprise 75% of the total. 

Taking capped notionals into consideration, impacting 22% of swaption trades over the period, suggests daily swaption volume averages over $50B or 42% higher than reported data, and is reviewed further when discussing SEFs below.

Figure 1

As a percentage of new trade activity in “all rate swaps”, swaptions have been increasing share in volume and counts overall, are moderately flat to down for USD, and declining in EUR, depicted in Exhibit 2 by week.   

As swaptions are not yet cleared instruments, the corresponding graphs below look at swaptions trades and notional as a percentage of uncleared rate swaps. 

One observed contrast is in EUR swaptions transaction count which is flat to slightly increasing, due to a combination of uncleared rates trading in non swaption instruments declining and cleared EUR trading inching up.

Figure 2

Swaptions On SEF

Swaptions presently are not executable on dealer to client SEFs, but do make up a portion of IDB SEF activity.  Market share by volume for swaptions among the 5 IDB SEFs is displayed in Exhibit 3, along with the percentage swaptions activity comprises at each SEF.  Note GFI ranks 5th in market share, however over a fifth of GFI rates volume is in swaptions, with an even greater weight on the USD chart.

Using direct SEF reported data, the impact of capped notionals can be assessed.  14% of all swaption trades On SEF were capped in notional terms, and affected 21% of USD swaption trades.  Direct SEF swaption notionals were 23% higher than SDR data, and 29% for USD.  On SEF capped notionals for swaptions are consistent with the rule of thumb to double the capped amount, as the observed impact on capped swaption notionals were 87% and 88% higher for Total and USD respectively. 

For Off SEF swaption trades, 25% and 28% of Total and USD transactions were capped.  Based on the direct SEF findings that support a doubling of capped notional amounts, average daily swaption volume increases from $36B to over $50B for all swaptions, and from $22B to $32B for USD contracts.     

Figure 3

Approximately 25% of new trade swaptions notional and trade counts are executed On SEF for all currencies and USD, representing risk transfer among dealers.  Straddle trades made up 30% of USD new swaption trades and 27% of corresponding notional during the period, of which 67% of straddle transactions were On SEF, accounting for 73% of SEF swaption notional. 

Activity by Swaption Type

USD Straddle volume tends to have shorter expiries among the group with 73% of notional terming within 1 year and 81% within 2 years.  Payer swaption volume expiry percentages are 55% and 73% respectively, while Receiver expiries by notional are 51% within 1 year and 65% within 2 years.  This observation provides a measure of liquidity in the instrument, as most of the volume would be eligible for CME’s Swaptions clearing service which intends to clear USD swaptions with maximum expiry of two years, and underlying tails up to 30 years.

Displayed in Exhibit 4 are notional volume for Straddles, Payers and Receivers:

Figure 4

Over the 10 weeks observed, in aggregate USD Payer swaptions exceed Receivers in notionals and trade count.  On a daily basis, Payers exceed Receivers 50% of the time in notional, and 70% of the time in trade count.   

Reviewing the transactions, 28% of Payers and 36% of Receivers were capped trades, impacting 50% and 57% of notionals respectively.  Doubling the notionals for capped trades reverses the observed data outcome, where Receivers would exceed Payers by 3.7% in notional compared to the 1.3% advantage Payers have in the reported data.

[Exotic Swaptions, a fourth category among Payers, Receivers and Straddles, comprise 3% of USD swaption notionals, and 5% of trade counts]

Notional volume for underlying maturities (tails) in the USD swaptions is displayed for five select tenors, which represent 74% of the notional (excluding exotics).  The graph stacks Receivers, Payers and Straddles, which reflect 67%, 70% and 90% of notionals in all tenors respectively.  The 30YR tail is the outlier displaying significantly less volume.

Figure 5

USD Swaptions expiring within 1YR having 10 YR tails made up 31% of transactions and 18% in notional during the period.  The exhibit below illustrates the non-standard nature of these conditional interest rate hedging instruments as strikes vary among the most popular group observed.  While rates among Straddles, Payers and Receivers are correlated and track each other, trading patterns display Payers having the most variability in strikes.  The data can be explained by a variety of strategies, such as combining Payers and Receivers at multiple strikes to construct zero premium transactions, replicating forward starting swaps using swaptions as a hedge, or simply expecting price movement and expressing rate expectations as in the case of Straddles which see strikes clustered close to current swap rates.

Figure 6

Swaptions are an established market, particularly in USD with short expiries, and enable participants to receive certain terms for a premium as opposed to delaying the entering into a swap. 

While the clearing of swaptions presents concerns particularly around default management scenarios, CME’s swaption clearing service will preserve netting sets among portfolios for clients and likely will spur further competition among SEFs.  

By Orlando Almodovar, Derivatives Analytics and Market Intelligence