FRAJUN19: buy ATM call/sell ATM +15bp call/sell 2 x ATM +20bp in a call ladder (or rather a 1 x 3 structure). Cost 1.4bp (indicative).
We have been advocating paying in the SEKFRAJUN19 contract on the back of the fact that inflation will most likely be close to the Riksbank's own trajectory over the next 6-9 months. Hence, it seems likely that the Riksbank will deliver two 25bp hikes up to next summer (25bp in December and another 25bp in July) as is reflected by their rate path. Current market pricing implies only 34bp of rate hikes up to mid-summer 2019. More specifically the JUN19 contract stands out as trading too low if hikes are delivered in December and July (or even better if the second hike is delivered in April). The potential upside is 14-18bp depending on when the second hike is assumed to occur (April or July).
However, with markets spooked by Brexit and Italy woes there is a risk that market will be reluctant to price in rate hikes in full. A messy outcome in one or both of these events could even make at least the second hike less clear. One way to limit the downside is to do a call ladder on the contract (or a sort of 1x3 structure). By buying an ATM call and financing it by selling three calls (one ATM+15bp and two ATM+20bp), it makes a cheap play on the Riksbank hiking twice. The loss is limited to 1.4bp (the cost of the structure) if FRAJUN19 fixes at the current level, unless the Riksbank hikes more aggressively than 3 x 25bp (December, April and September). The break-even level is some 2bp up from the current price. The potential upside is +13.5bp if the Riksbank hikes twice up to summer 2019. The chart below shows the pay-off structure together with what different Riksbank scenarios imply in terms of FRAJUN19 rate. The calculation is based on the assumption that 3m STIBOR fixes 12bp above the repo rate.
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