GLOBAL - Replicating optionality on inflation using the US dollar swaps market in recent years would have incurred one-fifth of the cost of buying inflation caps, according to research by PIMCO.

Growing disagreement among investors and economists about the threat of hyperinflation on the one hand and deflation on the other - and especially on the timing of the move from one regime to the next across different regions - has led to a surge in demand for inflation options in the form of caps and floors over the past 9-12 months.

But Mihir Worah, a managing director at PIMCO, said he did not recommend this market to clients because it remained illiquid and very expensive.

“The problem is that buyers and sellers - inflationists and deflationists - tend not to show up on the same day,” he said.

“In December, all anyone wanted to buy was options on inflation - now, everyone wants options on deflation.

“If you want to trade clips of $25m, you can get that done on the wire, but we’ve seen people attempting to trade billions, and it’s very difficult to match-up buyers and sellers for that sort of size.”

Buyers of inflation caps often fund the heavy premiums by selling inflation at lower levels.

But Worah said PIMCO recommended its clients synthesise the delta exposure of a cap using swaps - which are at least as liquid as cash inflation-linked bond markts in the UK and Europe - and then trade the gamma on that swap to maintain those delta levels as inflation expectations move. 

“That’s a positive-convexity payoff, and it’s a lot cheaper than buying the options themselves,” said Worah.

“After all, what are the dealer desks doing when they are selling you these options?

“They are charging you for doing the delta-hedging themselves, plus a huge illiquidity premium.”

A five-year cap on inflation at 5%- a position that costs a premium while inflation is below 5%, but which pays inflation at or above 5% - currently exhibits delta of about 0.1.

To replicate that with swaps on a notional value of $1bn, an investor would buy $100m worth of five-year inflation swaps.

As inflation expectations move, the delta of an inflation cap changes, and each month the holder of the swaps position buys or sells swaps to maintain the same delta.

Should today’s five-year inflation expectations of 2% move up to 5% over the course of one year, the delta on a cap would gradually rise, and the swaps position would grow larger as the investor maintained the same delta, until eventually moving from holding $100m notional in swaps to $1bn notional.

At that point, delta on both the cap and the swap would be 1.0.

This strategy replicates the same optionality of the cap, but without the crippling premiums.

The only exception would be if inflation expectations jumped exceptionally sharply and quickly, in which case it would be difficult to capture the gamma trade. 

“Our historical studies on this synthetic option position in the US show that you not only avoid paying out option premiums, you actually make money,” said Worah.

“Of course, the past doesn’t necessarily predict the future here - we haven’t seen inflation above 5% over the last 10 years.

“But even if we do see higher levels of inflation, this dynamic synthetic position will still save you money relative to paying the very expensive premium on the inflation cap.”