Case 043Global macro tradesHard

In the Republic of Kelmar inflation is 7% and the policy rate 6%. You expect the central bank to hike by 150 basis points over six months, while two-year swaps price only 50. Build the trade: which way you position, how you size it with a DV01 of Rs 1.9 lakh per Rs 100 crore, and what you make if you are right.

The situation

In the Republic of Kelmar, consumer inflation is running at 7% and the central bank's policy rate is 6%, so the real policy rate is about minus 1%. Your work on wages, food prices and the currency says the bank will hike three times, 50 basis points at a time, at its meetings in months two, four and six. The two-year swap curve prices a single 50 basis point hike, around month four, and nothing after it.

A two-year swap has a DV01 of about Rs 1.9 lakh per Rs 100 crore of notional: the position gains or loses that much for each basis point the two-year swap rate moves. The fund lets you lose up to about Rs 2 crore on this idea before you must cut it.

Your task

Which way do you position, how large should the trade be, what do you make if the market comes round to your view, and what could go wrong?

Quick check

If the market comes to price your three hikes, roughly how far should the two-year swap rate rise?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Pay fixed on two-year swaps: the position gains as the market prices more hikes. If the market comes to price your path, the two-year rate should rise about 83 basis points, not 100, because it averages the hikes over two years. On Rs 400 crore of notional, a DV01 of Rs 7.6 lakh, that is about Rs 6.3 crore, against a Rs 1.9 crore loss at a 25 basis point stop. Negative carry and a bank that waits are the risks.

Step 1Why pay fixed, and what are you actually betting on?

A tenant who expects rents to rise signs a long lease now at today's rent. Paying fixed on a two-year swap locks in today's two-year rate and receives the floating policy-linked rate, so the position gains when the market raises its expectations of future policy rates. Your bet is not that the bank hikes; the market already expects one hike. It is that the bank hikes 100 basis points more than priced. A real policy rate of minus 1% with inflation at 7% is the reason you think the market is too relaxed; say what the market may be seeing instead, such as an expected fall in food prices.

Step 2How far should the two-year rate move if you are right?

A two-year swap rate is roughly the average policy rate expected over the next two years. Hikes that arrive in months two, four and six raise that average by less than their full size: your path averages 125 basis points above today over 24 months and the market's 42, so the swap should move about 83 basis points, not 100. Candidates who multiply the DV01 by 100 overstate the gain by a fifth, and interviewers check exactly this.

Your hikes against the market's: the two-year rate averages the whole gap6.0%6.5%7.0%7.5%month 0month 6month 12month 18month 24six months: the view is testedyour view: 7.5%market pricing: 6.5%gap averages 83 bp over two years6.0% todayInflation 7%; policy rate 6%, a real rate of about -1%
Your path takes the policy rate from 6.0% to 7.5% through hikes in months two, four and six, while the market prices one hike to 6.5%; averaged over two years the gap is about 83 basis points, which is how far the two-year swap rate should rise if you are right.
The relationship
Δs2y≈50×22+50×20+50×1824−50×2024=125−41.7≈83 bp\Delta s_{2y} \approx \frac{50 \times 22 + 50 \times 20 + 50 \times 18}{24} - \frac{50 \times 20}{24} = 125 - 41.7 \approx 83\text{ bp}
50 x 22a 50 basis point hike in month two, in force for the remaining 22 of 24 months
24months in the two-year swap
Delta sthe expected rise in the two-year swap rate if your path becomes the priced path
What it says in wordsEach hike counts in the two-year rate in proportion to how long it is in force; the difference between your path and the market's is the move you are trading.
Step 3How big should the trade be?

Size from the stop, not the target. Put the stop at a 25 basis point move against you, which is what happens if the market starts to price no hikes at all. With a Rs 2 crore loss limit and 25 basis points of room, the DV01 can be about Rs 8 lakh; at Rs 1.9 lakh per Rs 100 crore, that is Rs 400 crore of notional, a DV01 of Rs 7.6 lakh. If you are right, 83 basis points times Rs 7.6 lakh is about Rs 6.33 crore; at the stop you lose about Rs 1.90 crore. A full 100 basis point move would be worth Rs 1.9 crore per Rs 100 crore of notional, the figure people quote, but the realistic move is smaller.

Paying two-year swaps on Rs 400 crore: what each outcome is worth-4-2+2+4+6+80stop: 25 bp against, -Rs 1.90 crorepriced today: 50 bpyour 150 bp: +Rs 6.33 crore050100150200Hikes over the next six months the market ends up pricing, basis pointsP&L, Rs crore
On Rs 400 crore paid, each basis point of two-year move is worth Rs 7.6 lakh: the position makes about Rs 6.33 crore if the market comes to price 150 basis points of hikes and loses about Rs 1.90 crore at a 25 basis point stop.
Outcome in six monthsTwo-year move, bpProfit on Rs 400 crore, Rs crore
Market prices your three hikes+83+6.33
Market prices two hikes, 100 bp+42+3.17
Pricing unchanged0about -0.83 carry
Stop: market removes the priced hike-25-1.90
The paid position earns about Rs 6.33 crore if your path is priced and half that if only one extra hike is, costs roughly Rs 0.83 crore of carry if nothing changes, and loses Rs 1.90 crore at the stop.
Step 4What could go wrong?

Three things. Carry works against you while you wait: you pay a fixed rate that already includes the priced hike and receive today's lower floating rate, roughly 42 basis points a year, about Rs 0.83 crore over six months on Rs 400 crore. The bank may hike as you expect but signal cuts next year, so the two-year rate rises less than the path suggests. And an external shock, a global sell-off or a sudden fall in oil, can make the bank pause. Set a time stop as well as a price stop: if the month-two meeting passes with no hike and no change in language, the thesis is weaker and the position should be smaller.

Where candidates lose it

The common loss is multiplying the DV01 by the full 100 basis point surprise. The two-year rate averages the policy path over two years, so hikes spread over six months move it by about 83 basis points, and the expected gain is a sixth smaller than the quick answer.

The second is sizing from the target instead of the stop. A candidate who says put on as much as possible because I am confident has told the interviewer they will not survive a bad month; size from the loss you can take at the point your thesis is proved wrong.

What the interviewer asks next

  • Would you rather express the view in one-year or five-year swaps, and why?
  • The bank hikes 50 at month two but says it will now pause. What do you do?
  • How would you hedge the trade against a global rates sell-off that has nothing to do with Kelmar?
  • How does the currency usually react to a surprise hike, and could you use that?

Company names and figures are illustrative.