Volatility: A Cheat-Sheet for Traders and Investors in Rates

Volatility in rates shows one of the most interesting dynamics compared to other asset classes. Unlike FX and equities, the skew shows considerable variation, in magnitude and even in sign, with changing macro-economic conditions. On top, a comparatively large share of derivatives markets influence the vol and the underlying in feed-back look.

Usually at any given point in time, the rates market is in any of the following three regimes

• Sticky-strike Regime: Very tight range trading of forwards. Realized and implied vols are range bound, no significant dvega/drate changes on the street, overall uncertainties low/stable
• Sticky-moneyness Regime: Trending rates regime, stable realized/implied vols, stable risk aversions/ risk appetite
• Uncertain Regime: Everything else. Usually accompanied by high vol, high policy and macro uncertainties.

Here is a quick cheat-sheet for traders and investors to identify which dynamics at play, based on the behaviors of traded prices.

Negative Skew (Current Skew Negative)	Positive Skew (Current Skew Positive)
Sticky-Strike Regime Expected Behavior 1.       Fixed Strike Vols : Independent of level of swap rate (or forward swap rate) 2.       ATM Vol: decreases as the swap rate increases	Sticky-Strike Regime Expected Behavior 1.       Fixed Strike Vols : Independent of level of swap rate (or forward swap rate) 2.       ATM Vol: increases  as the swap rate level increases
Sticky-Moneyness Regime Expected Behavior 3.       Fixed Strike Vols : increases as the swap rate increases 4.       ATM Vol: independent of swap rate level	Sticky-Moneyness Regime Expected Behavior 3.       Fixed Strike Vols : decreases as the swap rate level increases 4.       ATM Vol: independent of swap rate level
Classical Uncertain Regime Expected Behavior 5.       Fixed Strike Vols : decreases as swap rate increases 6.       ATM Vol: decreases	Classical Uncertain Regime Expected Behavior 5.       Fixed Strike Vols : increases as the swap rate level increases 6.       ATM Vol: increases

Speaking of volatility, here is an update of the cross asset volatility chart (see here for details, click to enlarge).

This chart presents volatilities across different asset classes in a comparable manner. Since the spurt of vol in rates since May this year, the volatility has switched back in to risk assets (commodities and equities) on the back of the Chinese Yuan devaluation. This supports the case that while positioning is important for rates, ultimately it is less about foreign central banks selling reserves, and more about which way the risk assets are heading. Historically that has been a better yardstick for directional calls on rates.