Remembering the range accrual bloodbath

Flatter US yield curve spurs demand for a product with a painful history

Kris Devasabai
11 Apr 2019

For interest rate volatility traders of a certain vintage, the flattening of the lower
reaches of the US yield curve has dredged up some unpleasant memories.

When the 10-year point of the euro yield curve plunged below the two-year point
in 2008, it produced losses estimated at up to $2.5 billion across the Street, as
dealers were forced to rapidly
rapidly
rapidly re-hedge
re-hedge
re-hedge their range accrual books – a then-
popular structured product that pays investors when the curve is upward sloping
between two specified points.

One trader – now on the buy side – recalls being told by his boss’s boss to exit
his own position, at the market’s all-time low. He says his bank lost “a few
hundred million” in the process: “Exotic desks in Europe collectively lost billions
that year, and it took them a very long time to recover from that. They never really
fully recovered.”

Those desks may have gone – or be living on in an enfeebled state – but the
range accrual product itself never went away. And notes referencing the US rates
curve are
are
are experiencing
experiencing
experiencing aaa new
new
new surge
surge
surge in
in
in popularity
popularity.
popularity

Investors in these products are essentially selling binary options that pay out if
the curve inverts and passes through the strike, which is typically set at zero.
rapidly re-hedge
This is a rare event, but with falling US yields already producing inversions in
some stretches of the curve, investors can currently earn a rich coupon for selling
these options.

So, it’s no surprise range accruals are flying off the shelves – an exotics trader at
one US bank estimates investors bought $4 billion to $5 billion of these notes in
January and February, which is double the usual volume.

As 2008 showed, range accruals can be dangerous.

The binary payout of digital options means dealers are long gamma when the
forward curve is positive and short gamma when it inverts. Put crudely, this forces
are
them to experiencing
unwind a new they
the steepeners surge in to
use popularity
hedge and replace them with
flatteners. The result can be a feedback loop, known as a ‘gamma trap’, in which
hedging pushes the market against the dealer, forcing them to re-hedge again
and again, at significant cost.

When Risk wrote about these products before

before
before the 2008 meltdown, some traders
were aware of the danger, but downplayed it. Others dismissed it altogether.
When the curve inverts, argued one exotics head, “it’s for macroeconomic
reasons that have nothing to do with locally re-hedging exotic derivatives books”.

Today, some traders and strategists again downplay the risks. The US rates
market is far larger than the euro market in 2008, so there should be less risk of
the tail wagging the dog. The products are also more conservatively structured
and risk-managed. Most notes reference the widest and most stable part of the
curve – between the two- and 30-year points – and the strikes on digital floors
have shifted to below zero to give banks more breathing space before they
become short gamma.

But not everyone. The former bank trader who was stopped back in 2008 says he
is keeping one eye on the market in case there’s a chance for his fund to make
before
back the money he lost a decade ago. And a trading head at one European bank
– who remembers the episode well – worries his team lacks that kind of
experience. Most of them started trading after the range accrual bloodbath. They
should be thinking about the dangers, he says. He’s not sure they are.

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