BNP Paribas and Barclays Capital say the medium-term swap rate is overvalued and recommend investors take long and short exposure to take advantage. BNP is pitching a butterfly trade, in which an investor sells swaptions in the middle portion of the curve and then does the opposite in the outer ends, or wings, of the curve. Barclays is also recommending a butterfly trade, specifically one executed with a straddle structure.
Anthony O'Brien, derivatives strategist at Barclays in London, said volatility has been low in the two-year portion of the swap curve due to the perception that the European Central Bank has put interest-rate hikes on hold. Instead, volatility has stretched out further along the curve into the five-year portion. Both firms expect volatility will return to the two-year area of the curve as the equity markets improve.
In the BNP trade, investors sell out-of-the money one to five-year swaptions in which the investor pays fixed and receives floating, and buys two- and 10-year swaptions to take advantage of an expensive five-year swap, according to Eric Oynoyan, interest-rate strategist. In the Barclays trade, investors sell a three-month option on the five-year portion of the curve and buy three-month options on the 2-year and 10-year portions, O'Brien explained.
