Bund Skew Forms Perfect Smile on Hedging of Le Pen Risks

  • French election risks drive 25-delta risk reversals to zero
  • Schatz squeeze adding downward pressure further out the curve

For the bund options market, Marine Le Pen as France’s next president seems no longer just a remote tail risk.

Demand for call options on bunds has increased steadily in recent weeks, pushing up three-month 25-delta normalized risk reversals to zero from minus 0.25 vol at the end of 2016, near the most skewed toward puts in five years. Still, the market is underpricing the possibility of an increase in implied volatility on lower yields driven by a flight to quality. Volatility, which moved in the same direction as yields since the Brexit vote, has flipped this month.

Record-low schatz yields are also driving down rates further out the curve, richening the call skew. Two-year German yields fell 21 basis points this month and touched an all-time low of minus 0.958 percent on Feb. 24. The French election risk premium may account for about 20 basis points of widening of the schatz-eonia spread, which will fade on any unwinding of Le Pen risks, but the underlying driver of the spread remains the European Central Bank.

Investors worry that polls underestimate the risk of a victory for the National Front leader following the Brexit vote and Donald Trump’s win last year, although the French election may have a lower probability of surprise. Modest changes in polls are having an amplified effect on pricing the Le Pen risk in selective areas of markets.

* Note: Tanvir Sandhu is an interest-rate and derivatives strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice.

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