Home > Bond Market, TIPS, Trading > Inflation Trading is Not for the Weak

Inflation Trading is Not for the Weak

I was prepared today to write a column about horse racing and value investing…that will have to wait until tomorrow…when this article was sent to me by about a dozen people:

Deutsche Bank Said to Face Possible $60 Million Derivative Loss

The article was sent my way because the loss was tied to a trade that used US dollar inflation derivatives, and since that’s a market I basically started back in 2003 folks figured I might want to know. And I do.

The inflation derivatives market is not huge. The chart below shows rolling 12-month inflation derivative volumes (source: BGC Partners) through last September, which was the last time I went looking for the data for a presentation. Total interbank volumes are around $10-15bln per month; customer volumes are not included here but are not insignificant (any more).

Most inflation books, especially these Volcker Rule days, are run pretty close to the vest. Most of these volumes will be set against customer flows, or against bond breakevens, or against other positions on the inflation curve. Net risk positions for any derivative book, especially these days, are pretty small…which is why Deutsche is investigating whether risk limits were breached in this case. In principle this should be easy to figure out, since DB and every other bank has risk control specialists whose job it is to monitor these risks.

But inflation risks are complex. Our firm breaks fixed-income risks down into six basis risks that add up to the net risk of a bond. For a TIPS bond, there is just one risk; for a corporate bond there will be six. Our risk schematic starts from real rate risks and builds up – unlike in most risk systems, which start with nominal risks and try to force real bonds to fit. Inflation-linked derivatives also have commodity deltas implied, since they are tied to headline inflation and headline inflation is tied largely to energy prices. Geez, I could write a book on this – it would be a combination of “Inflation Risks and Products[1] and, in this case, “Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports.”

Suffice it to say that even really sharp investors don’t always quite get it when it comes to inflation. In early 2014, a prestigious investment management firm took a multi-billion-dollar bath on a “risk-parity” product that hadn’t truly understood how to figure out the risks of TIPS. How much more difficult, then, is it for risk control officers, many of whom have shiny new Ph.D.s and very little direct market experience? A fast-talking trader who knows something about the product can, if he is unscrupulous, persuade risk control that he is not really taking risks that he knows, or ought to know, he is taking.

In short, I am sympathetic with the risk control guys in this case. They were probably outgunned by a slick operator pushing the limits of his limits. It’s almost assuredly the case: the market, as large as it is, is too small in the Volcker Rule era to allow the accumulation of a prudent position of large enough size to cause this sort of loss – especially in the recent period of exceptionally low market volatility.

This, then, is an object lesson: if you’re running inflation risk, and you think it’s pretty much like running nominal rate risk – you’re wrong, and you should get help before your firm’s name is the one in the Bloomberg article.[2]

Tomorrow, we can talk about horse racing.

[1] In which I co-wrote a chapter, on commodities actually, with Bob Greer.

[2] To be fair, in this case the problem was the combination of ignorance and what appears to be malfeasance. If you’re careful with your control structures and only hire high-quality people of sterling reputation, you shouldn’t have a problem with the second part of this formula.

Categories: Bond Market, TIPS, Trading

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