European short-dated rates volatility lows continue

The surge in long-dated interest rate volatility has cast its shadow over the European swaption market during the last nine months, but now at the other end, short-dated volatility has fallen.

Dealers' opinion is divided over the likelihood of any further easing of interest rates by the European Central Bank. But short-dated volatility in the interest rate derivatives market has fallen steeply during the past month.

Volatility on three-month, 10-year options peaked at around 16% in mid–December last year, and has now come down to 12.9%.

“We are in a period when short rates may be on hold for an extended period, so volatility has damped down,” said Fred Goodwin, a London-based swaps trader at Lehman Brothers. There also seems to be less position risk in the market, according to Goodwin. Money managers are typically neutral, while leveraged money is at a low level, he added.

Meanwhile, the surge in long-dated volatility that began around April 2001 - due to Danish pension funds and insurance firms hedging their guaranteed annuity obligations – seems to have relented. For example, volatility on the five-year, five-year option is now at 11.2%, having peaked at around 15% in Q3 last year.