SmartInMoney

 

 

 

 

When investors become uncertain about market direction, they seek to buy insurance to protect them against the worst that can happen, and that means buying options. An option is a derivative contract that gives the purchaser the right, but not the obligation, to buy or sell an asset at a certain price. Those that sell options logically raise their prices in response to higher demand for insurance. The premium increase shows up in the “implied volatility” of the option, which indicates how wild investors expect market swings to be.

 

In the stock market, this measure is known as the VIX (volatility index) and is a widely watched indicator of confidence. It soared in the wake of the collapse of Lehman Brothers last fall. But it has slowly subsided and is now down to pre-Lehman levels, a sign that investor confidence is returning.

 

But as volatility has subsided in equities, it has popped up in debts. The implied volatility of interest-rate swap options has shot up in recent months, indicating that investors are uncertain about long-term interest rates. Ten-year Treasury bond yields have swung between just over 2% and almost 4% since December. Although many countries are experiencing mild deflation, investors fret and rush to protect themselves.

 

Interest-rate swaps allow investors and borrowers to switch from a fixed rate to a floating, or variable, rate and vice versa. You can buy an option to take part in a swap, a contract called a “swaption”. The agreement will specify whether the buyer of the swaption will be a fixed-rate receiver (like a call option on a bond) or a fixed-rate payer (like a put option on a bond).