Inflation option auction plans

Deutsche Bank and Goldman Sachs plan to add options on eurozone inflation in April to the economic derivatives product suite the two firms jointly offer, based on the parimutuel derivatives call auction technology developed by New York-based Longitude.

Deutsche and Goldman currently offer economic derivatives on the US non-farm payroll employment statistic, the US Institute for Supply Management manufacturing index and US retail sales, excluding automobiles.

The firms will host parimutuel auctions for three- and six-month options on the European Harmonized Index of Consumer Prices (HICP), excluding tobacco. “The HICP is the main inflation index for the eurozone, which will allow people to hedge their exposures to index-linked products,” says Torquil Wheatley, vice-president of economic derivatives at Deutsche Bank in London.

Deutsche and Goldman hope these longer-dated products will appeal to a wide range of inflation hedgers, including corporates, asset managers and insurers, along with the hedge funds and banks that have been the most active players in the existing, shorter-dated economic derivatives. The two firms themselves could use these inflation options to structure inflation-linked investment products for retail investors, which have been growing in popularity in Europe.

Judging by the massive increase in inflation-linked swap volumes, much of which is tied to inflation-linked retail product development (see page S13 of this month’s RMI supplement), a significant market for this new type of inflation option could exist.

“We think banks will be quick adopters,” says Bill Cassano, vice-president of fixed income, currency and commodities at Goldman in New York. “In the longer term, we expect a lot of interest from corporates for this as well.”

Wheatley adds: “The market for inflation-linked bonds is remarkably illiquid – issuers are not only exposed to movements in interest rates, but also to inflation. There are no opportunities to hedge short-term inflation exposures.”

Once the eurozone inflation product is running, the firms say they will launch economic derivatives on US inflation, probably the Consumer Price Index for Urban Consumers, in June and UK inflation, probably the Retail Price Index minus housing, soon after.

The firms are considering a range of other statistics, including the IFO Business Climate Index (from the IFO Institute in Germany) and retail sales. However, they decided to prioritise inflation based on feedback from clients. “When we were marketing our shorter-term options people said ‘this is great – but what about inflation?’,” Wheatley says. “We thought this might be difficult, but realised it is, in fact, a shorter-term version of existing [inflation] products.” The firms plan a roadshow in late March or early April for the HICP product.

Deutsche and Goldman officials say the existing products have gained steam since the first, US non-farm payroll, debuted in October (Risk November 2002, page 18). “Payroll has been the most interesting, active and liquid,” Cassano says. “Each of the statistics has shown a trend of growth, but payroll started out bigger and has grown more quickly.” However, the firms refuse to disclose volume figures.

The auction results have proved to be a useful guide to market sentiment, though they have not had predictive value. “The number shows what the market thinks – what the market’s sensitivity is,” Wheatley says. For example, economists predicted that the December 2002 release of the non-farm payroll statistic for the previous month would show an increase of 35,000 jobs, but the auction consensus came out at 70,000, Wheatley says. “The actual figure released by the government came out at minus 40,000,” he adds.

“Very savvy hedge funds that bought puts at zero or minus 25,000 made out like bandits,” Wheatley says. But most of the participants are using the products as a hedge, he notes. “It can be a cheap form of insurance against this type of surprising number coming out,” Wheatley adds.

Deutsche and Goldman officials say the number of people watching the auctions is growing. They hope these watchers will become auction participants. “Yesterday’s watchers are today’s participants,” Cassano says. “It’s a natural progression.”