FxWirePro: Hedge dual-risk in EUR rates after recent developments via Vega strategy

The medium-term view on the euro remains bullish in anticipation of a pivot in ECB policy. The recent political developments in the Euro area have also garnered the attention.

Buy EUR bottom-right vega EUR vega is typically well explained by short expiry vol and long-end forward rates (refer above nutshell and graph). The 1y10y vol and the 10y10y forward rate account for 83% of the 10y10y vega move since 2000. The same model is valid for 7y30y or 15y30y.

Higher gamma vol drives vega up, but higher long maturity forwards drives vega down.

Vega would follow gamma up in a bond sell-off, and especially so if the long-end of the curve bear-flattens.

But vega would also move up in a flight-to-quality scenario bull-flattening the EUR curve - even if gamma vols do not spike significantly.

So long EUR vega positions are a good hedge against such a debacle risk.

We expect yields to de-anchor in 2018. Yet, various risk scenarios could prevent rates from taking off.

The risk of an equity market correction is one of them. If coupled with lower equity prices and wider credit spreads, even a limited decrease in rates would be a pain scenario for various institutional investors, and especially so for pension funds and insurers.

In its last GSFR, the IMF highlights the vulnerability of lifers to market and credit risks. A sharp fall in risk asset prices combined with a flight to high-quality sovereign bonds would amount to a double hit on insurers and PFs balance sheets.