Relative value analysis of interest rate derivatives: A study

Abstract

Relative Value Analysis has been used as a technique by the traders across multiple asset classes to exploit the deviations from the “normal” behaviour. Relative Value (RV) trading has developed in the financial markets in response to the limitations of directional trading – as the players have always felt that taking a view on interest rates going up or down provides for a fairly narrow range of trades. RV trades usually tend to take a non directional view on any single underlying asset and, instead, take advantage of the relative movement between two or more underlying assets (from the same asset class or different). The view is taken on the spread movement and unlike popular belief its application is not just a purely mathematical technique but is used in conjunction with underlying economic logic. It becomes even more interesting in the Interest Rate space with a huge flow driven secondary market for Interest Rate Products and their derivatives. With the post subprime nervousness and exceptional response of the Central banks across the globe, RV trading did leave the centre stage for a while but there are opportunities and proactive players (read hedge Funds and Prop desks) are back. There is not much literature that explores this area and our study aims to fill the gap by providing a framework for RV trading from the point of view of an Interest Rate trader. The objectives of the study are to provide enough background to the reader to spot the potential RV opportunities floating in the market, as and when they arise. Also, this study intends to span the logic driving the action of different players operating in the market. We try to look at the cases when RV trading works and also try to provide (with example from the market and using products like Steepeners/ Flatteners/ Butterflies/ Condors/ Directional Steepeners/ Wedges etc.) the situations where RV trading has not worked favourably. We will also cover the macroeconomic analysis in relation to the RV structures.