As Japan ends its 17-year period of negative interest rates, market volatility is expected as the policy beds in. We look at how market participants can use Interest Rate Swap Volatility indices to their advantage.
This March, Japan became the last country in the world1 to end a policy of negative interest rates.
The Policy Board of the Bank of Japan (BoJ) announced2 that a long period of deflation has come to an end and wages are rising, making it the right time to increase short-term interest rates from -0.1% to 0-0.1%.
The central bank also abandoned yield curve control, a policy that has been in place since 2016 capping long-term interest rates around zero, and discontinued purchases of risky assets.
The BoJ says it will target a 2% price stability target and “conduct monetary policy as appropriate, guiding the short-term interest rate as a primary policy tool, in response to developments in economic activity and prices as well as financial conditions from the perspective of sustainable and stable achievement of the target”.
The immediate response to rising interest rates has been a fall in the yen which dropped more than 1% the day of the announcement. However, the impact on the bond market has been minimal with market participants having largely anticipated the BoJ’s measured increase.
Tactical opportunities
Looking further ahead, if wage-driven inflation grows, long-term yields will likely start to price in the further hikes and term premiums will increase, reflecting the uncertainty over the outlook for inflation and monetary policy.
However, this evolving policy stance presents tactical opportunities for active managers to capitalise on the inefficiencies in the Japanese bond and interest rate swap markets during this period of increased volatility.
Yet to make the most of such opportunities, market participants need an indication of the expected volatility of the swap rates.
Last year Parameta Solutions, the data and analytics division of TP ICAP Group, the world’s largest inter-dealer broker, launched its Interest Rate Swap Volatility (IRSV) indices which provide market participants with a model-free measure of spot implied volatility in the major interest rate swap markets.
Derived from unparalleled access to interest rate swaptions market data, the index consolidates all the volatility information at a specific tenor/expiry into a single measure of implied volatility.
For OTC derivative market players looking at Japan, JPY IRSV offers a basis point measure of JPY Interest Rate Swap Volatility with 35 points on the volatility surface available covering 1Y, 2Y, 5Y, 10Y and 20Y Swap Tenors option with option expiries of 1M, 3M, 6M, 1Y, 2Y, 5Y and 10Y.
IRSV is a model-free measure of implied volatility, and, as a recent BIS working paper3 found, predictions of interest rate swap volatility based on model-free implied volatility have superior predictive power over other commonly used volatility forecasting measures.
For those wanting to take advantage of the more favourable interest rates in Japan, but who want to manage the expected volatility, Parameta’s JPY IRSV indices offer a useful tool to make the most of the markets.
To find out more…
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