Deutsche

DeutscheBank
Bank
Corporate
Corporate &Investment
& InvestmentBank
Bank

#1 USD Inflation Swaps

#1 USD inflation Options

Strictly Private and Confidential

CPI – The Consumer Price Index

Consumer Price Index
Definition of CPI

The Consumer Price Indexes (CPI) program produces monthly data on changes in the prices
paid by urban consumers for a representative basket of goods and services.

Food
4
7 14 Energy
6 Housing

7 10 Apparel
Transportation
%
Medical Care
11
Recreation
3 Education and Communication
37 Other Goods & Services

Source: Bureau of Labor Statistics.

The index includes owner occupied housing using a rental equivalence approach
It is published once per month, usually around the middle of the following month
3
 Energy is by far the most Volatile component of CPI
(Transportation costs are highly correlated with Energy)

Annual Volatility of CPI Sub-Indices (1994-2012)

Food and
Beverage Prices Energy
are much less
volatile than Food & Beverages
Energy
Housing

Apparel

Transportation

Medical Care

Recreation

Education & Communication

Other Goods & Services

0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50%

Source: Deutsche Bank
4
 CPI History
Inflation is Seasonal

Inflation is generally
higher leading into
the Summer and
lower heading into
year-end

This can be observed

by comparing
seasonal adjusted
CPI (CPI_INDX) with
non-seasonal
adjusted CPI
(CPURNSA)

Source: Bloomberg : CPI INDX <Index> CPURNSA <Index> HS 5

 TIPS Issuance has Increased Significantly

TIPS Outstanding by Issue Year in $mm (as at 16 Jan 2013)

Treasury has
committed to
160,000
support the TIPS
market as it
provides a
140,000
diversifying
source of funds
120,000
Daily Trading
Volume is
approximately
100,000
$11 Billion

80,000

60,000

40,000

20,000

0
2008 2009 2010 2011 2012

6
Source: Bloomberg / Deutsche Bank Forecast
 US Inflation Derivative Market has been Growing

Interdealer Volumes in $'mm

80,000
A reflection of an
increased number of
clients participating Options
70,000
in the market
TIPS ASW
Daily Trading
60,000
Volume is Swaps
approximately
$1 Billion
50,000
Especially strong
growth in Inflation
Options 40,000

Deutsche Bank’s
currently has 25% 30,000
market share in US
Inflation derivatives
(BGC Partners Inter- 20,000
dealer Statistics)

10,000

2007 2008 2009 2010 2011 2012

Source: BGC Partners 7
Strictly Private and Confidential

Inflation-linked Products
 Inflation Products : TIPS

The TIPS market is TIPS (“Treasury Inflation Protected Securities”) are securities issued by the US government
the largest inflation-
linked market in the that offer investors inflation protection
world. Regular
auctions are The principal is accredited daily based on the CPI-Urban index and repaid at maturity
conducted in 5y, 10y
and 30y TIPS subject to a minimum of par, providing deflation protection i.e. embedded deflation floor

Semi-annual coupons paid on TIPS are based on the inflation-adjusted principal

TIPS coupons and principal repayment at maturity

10% 140%
9%
120%
8% Real Coupon Inflation Notional
7% 100%

6%
80%
5%
60%
4%
3% 40%
2%
20%
1%
0% 0%
9
1 2 3 4 5 6 7 8 9 10
 10,000
15,000
20,000
25,000
30,000
35,000
40,000
45,000
50,000

0
5,000
15-Apr-13
15-Jul-13

2013
15-Jan-14
15-Apr-14
15-Jul-14
15-Jan-15
15-Apr-15
15-Jul-15
15-Jan-16
15-Apr-16
15-Jul-16
15-Jan-17
15-Apr-17
15-Jul-17
15-Jan-18
15-Jul-18
15-Jan-19
TIPS Issues

15-Jul-19
15-Jan-20

Data Source: Bloomberg

15-Jul-20
15-Jan-21
15-Jul-21

2015 2017 2019 2021

15-Jan-22
15-Jul-22
15-Jan-23

2023
15-Jan-25

2025
15-Jan-26

15-Jan-27

15-Jan-28
15-Apr-28
15-Jan-29
15-Apr-29
Total Market value is approximately $1 Trillion

15-Apr-32
2027 2029 2031 2033
2035
TIPS Outstanding by Issue in $mm (as at 12 February 2013)

15-Feb-40

15-Feb-41
2037 2039 2041

15-Feb-42
10
 TIPS, Real Rates and Inflation

TIPS provide a real TIPS provide exposure to real interest rates rather than inflation
rate of return. To
express a view in
inflation, one can
Coupons and Redemption amount grow at the inflation rate. However, these are discounted at
trade the spread the nominal rate to determine the Present Value. Accordingly, the market values of TIPS are a
between TIPS and
nominal treasuries function of both future inflation expectations and nominal rates

Breakeven trades can isolate the exposure to expected inflation

TIPS Breakeven = Long TIPS bond + Short Treasury of similar maturity

11
 Inflation Swaps

Inflation swaps are Inflation swaps offer a mechanism to trade inflation over a given time horizon
the most liquid
inflation derivatives,
providing a clean
At maturity, one party pays the cumulative percentage increase in the reference inflation index
way to trade in over the life of the swap in exchange for an annually compounded fixed rate
inflation

ISDA documentation typically employed

Fixed

(1 fixed) N 1

CPI ( N )
Happy Client 1
CPI ( 0 )
Floating

12
Inflation Products: Inflation Swap Example

Client asked DB to quote a price to buy a 5-year inflation swap

Agrees on a fixed rate of 2% (“Swap Breakeven Rate”)

Client will “break even” if inflation turns out to be 2% per annum over the 5-years; Accordingly,
will lose money if inflation is less than 2% and make money if inflation exceeds 2%

If actual inflation over the 5 years turns out to be 3% per annum, the client be paid the
difference between 3% compounded for 5-years and 2% compounded for five years

Happy Client

Fixed

(1 2% ) 5 1

CPI ( 5 )
Happy Client 1
CPI ( 0 )
Floating 13
 Product : Inflation Swaps
Curve

Zero Coupon Inflation Swap Levels

3.50%
Typically traded in
discrete years from
1-year to 30-years
3.00%
Often traded on a
forward basis
e.g. 5y5y or 1y9y Headline

2.50% Core
The zero-coupon
structure makes it
Level

possible to match
an exact cash flow
profile by combining 2.00%
swaps of different
maturities

Trading in Core
Inflation recently 1.50%
initiated by
Deutsche Bank

1.00%
1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 12Y 15Y 20Y 25Y 30Y
Maturity

14
Range Trade 5y5y Inflation Forward
More convenient to implement this in inflation derivatives than TIPS

As historically forward-starting inflation, e.g. 5y5y, has always been

within a tight band

Forward-starting tends to be the easiest way to implement this and has

other attractive features e.g. no seasonality, relatively flat carry

Historical 5Y5Y Inflation Swap Levels

400 bps

350 bps

300 bps

250 bps

200 bps

150 bps

100 bps
Aug-04

Aug-05

Aug-06

Aug-07

Aug-08

Aug-09

Aug-10

Aug-11

Aug-12
15
Source: Bloomberg LP Past Performance is no Guarantee of Future Results
 Implied Inflation
TIPS vs. Inflation Swaps

TIPS vs. Swap Breakevens

Expected Inflation
implied by Inflation 3.25%
Swaps is higher than Swap BEI
that implied by TIPS
Breakevens 3.00% TIPS BEI

For the most part,

reflects a 2.75%
supply/demand
imbalance

No natural sellers of 2.50%

Inflation swaps

Large seller of TIPS: 2.25%

The US Government

Why is this not 2.00%

arbitraged away?

1. Limits on balance
sheet capacity 1.75%

2. Mark-to-market risk
1.50%
2 5 10 20 30
Years

Data Source: Bloomberg LP

TIPS Asset Swap
The National Bureau of Economic Research (NBER)*

“Why Does the Treasury Issue Tips? The Tips–Treasury Bond Puzzle”
Matthias Fleckenstein, Francis A. Longstaff, and Hanno Lustig
NBER Working Paper No. 16358
September 2010

http://www.nber.org/papers/w16358.pdf

“To the best of our knowledge, the relative mispricing of TIPS and Treasury bonds
represents the largest arbitrage ever documented in the financial economics literature.
The TIPS–Treasury arbitrage poses a major puzzle to classical asset pricing theory.”

* The NBER is the nation's leading nonprofit economic research organization. Eighteen of the 33 American Nobel Prize
Winners in Economics and six of the past Chairmen of the President's Council of Economic Advisers have been
researchers at the NBER. The more than 1,000 professors of economics and business now teaching at colleges and
universities in North America who are NBER researchers are the leading scholars in their fields,
http://www.nber.org/info.html
17
Product : TIPS on Asset Swap
The link between TIPS and Inflation Swaps – no net exposure to inflation

Obtain duration/yield pickup via a top-credit quality assets (US Sovereign)

Competing product to Nominal Treasuries, Agencies, …

E.g. Post as collateral, replace treasury holdings, or hedge duration (with Repo) inexpensively

Fixed TIPS Assets Swap Levels

4.00%
Fixed TIPS ASW
3.50% Treasury

3.00%

2.50%
Level

2.00%

1.50%

1.00%

0.50%

0.00%
2013

2015

2017

2019

2021

2023

2025

2027

2029

2031

2033

2035

2037

2039

2041
Source: Deutsche Bank Closing Levels Maturity
 Product : TIPS on Asset Swap
Floating TIPS Asset Swap

Earn an carry over repo rates / fed funds

TIPS are easy to repo as they are US Government Treasuries

Floating TIPS Asset Swap Spreads

1.00%
3mL+Spread
FF+Spread
0.80%

Feb ’42 offers a much

higher spread than 0.60%
Feb ’41s as it has a
much lower coupon
Pickup

(0.75% vs 2.125%) 0.40%

0.20%

0.00%

-0.20%
2013

2015

2017

2019

2021

2023

2025

2027

2029

2031

2033

2035

2037

2039

2041
Maturity
Source: Deutsche Bank Closing Levels
Product : TIPS on Asset Swap
Mechanics

Investor buys a TIPS

Investor agrees to pay away all the cash-flows (P+I) from the bond

Investor receives in return Libor + X% until maturity

Investor receives Par (100) at maturity

Inflated Notional Inflated Notional

CPI CPI

TIPS Investor

Libor + X

Notional
Product : TIPS on Asset Swap
Example: How to make almost risk-less money

Buy $100m Notional of TIPS maturing in January 2014 i.e. $130mm Dirty Price

Fund the $130mm on overnight repo (current rate 0.06%, say)

Swap out all the TIPS cash-flows in exchange for 3mL-0.07% coupons + $130mm on
Maturity Date (current 3m Libor rate is 0.29%)

Accordingly, asset swap will pay back the full $130mm on maturity date

3m Libor is almost always higher than repo rates

(as it should be given it is an uncollateralized rate)

Accordingly, assuming no change in the spread between Libor and Repo rates,
earn carry of 0.29%-0.07% - 0.06% = 0.16% per annum on $130mm
Strictly Private and Confidential

Inflation Products – ETPs, TRS and Notes

Exchange Based Products
DB is an active market maker in Fixed Income ETPs

A large number of ETFs track inflation-linked sovereign bonds

e.g.TIP, WIP, STPZ, IPE, LTPZ, STIP, TIPZ, TDTF, TDTT, ITIP, GTIP, VTIP, etc.
New ETFs: Breakeven: INFL, DEFL, UINF, SINF, RINF, FINF and Active: ILB
First Inflation ETNs were recently listed

INFL Powershares DB US Inflation ETN

DEFL Powershares DB US Deflation ETN

Combines Long TIPS with Inverse Treasury position

Daily liquidity provision at NAV

Live market making

Designed such that 1bp change in inflation expectations equates to

a 10c change in ETN price

Different Credit and Tax Treatment compared to ETFs

23
CME considering launching Futures on CPI and TIPS
Total Return Swaps and Inflation-linked Notes

Total Return Swaps

– Allows clients to go long or short cash instruments in an unfunded form

– E.g. 1: Return of the 10+ year TIPS index vs Libor +/- Spread

– E.g. 2: Return of Overall TIPS Breakeven Index vs Libor +/- Spread

Inflation-linked Notes

– Creation of a customized note issued by DB or a Third Party

– E.g. 1: Provide coupons of Annual Inflation + 1.50%

– E.g. 2: Provide coupons of 1.5 Leverage x Annual Inflation

Strictly Private and Confidential

Inflation Products – Options

Understanding Inflation Options
Two key concepts

1) Inflation Options are either

CAPS i.e. Calls

or

FLOORS i.e. Puts (strikes can be negative)

2) Inflation Options are either

YEAR-on-YEAR (YoY) References Annual Inflation

or

ZERO COUPON (ZC) References CPI (cumulative inflation)

26
 Year on Year Inflation Options
Regular payments based on annual Levels of Inflation

Year-on-year Payout based on difference between YoY Inflation and Strike each year
options generally
have annual pay
dates, but more
frequent payouts
are possible YOY Inflation by Calendar Year
Often these 4.5% 4.1
options are
4.0%
embedded in
3.4
inflation-linked 3.5%
notes
3.0% 2.7
E.g. $100mm 3%- 2.5%
strike five-year 2
cap starting in 2.0%
2004 would have
paid out $0.4mm 1.5%
at the end of 2005 1.0%
and $1.1mm at the
end of 2007 with 0.5% 0.1
no other
payments 0.0%
2005

2006

2007

2008

2009
27
 Zero Coupon Options
Payment on maturity based on cumulative inflation and compounded strike

There is Single payment at maturity based on cumulative inflation from inception

particularly good
liquidity in 0%
options since
they are similar to CPI Index Value
the redemption
options 225
embedded in TIPS
219.964
220 218.011
-0.89%
215

E.g. $100mm 0%-

210
strike two-year
floor with a 205
starting reference
of July 2008 will
pay out $0.89mm 200
(-0.445% per
Jul-07

Jul-08

Jul-09

Jul-10
Jan-07

Apr-07

Jan-08

Apr-08

Jan-09

Apr-09

Jan-10

Apr-10
Oct-07

Oct-08

Oct-09
annum deflation)
in October 2010
(3-month lag)

28
Understanding Inflation Options: Inflation Volatility
Market vs Economist Expectations

Implied Volatility
is too high
relative to
Negative skew in economist
the options market. expectations
Economic theory
suggests prices are
sticky downwards i.e.
market implied ‘Fat tailed’
probability of distribution
deflation is too high means wings
have too much
value

29
Building a CPI Curve

30
Building the CPI Curve
Process

Given market quotes for the zero coupon inflation-swap rates or TIPS breakevens it is possible
to build a forward CPI curve

Constructing a complete forward curve involves

(a) extracting future fixings from quoted ZCIS rates

(b) interpolating the available points to obtain the inflation trend

(c) adding the CPI seasonality

1. For the quoted tenors the future fixings can be obtained using:
Implied Ref CPI t+tenor = Ref CPI t x (1+ ZCIS rate) tenor 240

220
2. Interpolation between quoted ZCIS rates can be Projected CPI Trend
200
linear, cubic, which may lead to a smoother
180
forward curve, or other depending on the data
160
3. To obtain the monthly CPI projections seasonality 140
needs to be taken into account (next slide) 120

100
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30

31
Source: DB Global Markets Research
Building the CPI Curve
Example

Co n st ru ct io n o f t h e f o rw ard CPI cu rve

C P I P r o je c t ed M o n t h ly Re m o vin g t h e T r e n d C P I In c o rp o r a t in g se a so n a l Fu ll C P I
In d e x v a lu e se a so - se a so n a l co m p o n e n t b y lin e a r co m p o n e n t curv e
f rom n a lit y in t er p o la -
Z C IS t io n

Sep-09 109.8420 0.08% = 109.8420/exp(0.08% )= 109.7541 109.7541 = 109.754 x exp(0.08% ) = 109.8420

Oct-09 0.02% 109.9722 = 109.972 x exp(0.02% ) = 109.9942
Nov-09 -0.19% 110.1902 = 110.190 x exp(-0.19% ) = 109.9810
Dec-09 0.17% 110.4083 = 110.408 x exp(0.17% ) = 110.5963
Jan-10 -0.46% 110.6263 = 110.626 x exp(-0.46% ) = 110.1175
Feb-10 0.14% 110.8444 = 110.844 x exp(0.14% ) = 111.0002
M ar-10 0.35% 111.0624 = 111.062 x exp(0.35% ) = 111.4523
Apr-10 0.23% 111.2805 = 111.280 x exp(0.23% ) = 111.5363
M ay-10 0.05% 111.4985 = 111.499 x exp(0.05% ) = 111.5541
Jun-10 -0.08% 111.7166 = 111.717 x exp(-0.08% ) = 111.6275
Jul-10 -0.29% 111.9346 = 111.935 x exp(-0.29% ) = 111.6108
Aug-10 -0.02% 112.1527 = 112.153 x exp(-0.02% ) = 112.1302
Sep-10 112.4607 0.08% = 112.4607/ exp (0.08% ) = 112.3707 112.3707 = 112.371 x exp(0.08% ) = 112.4607

120 14 trend
12 % f orward rat es
118 CPI curve with seasonality
10
projected trend
116 8
6
114
4
112 2

110 0
-2
108 -4
106 -6
2009 2010 2011 2012 Oct-09 Oct-11 Oct -13 Oct -15
32
CPI Volatility Models

33
Jarrow and Yildirim (2003)*

Foreign Currency Analogy

The “Real” is a “foreign currency” pegged to the value of a basket of goods and services

Real Rates are the interest rates in the “foreign currency”

CPI Index is the exchange rate between USD and the “Real” Currency

Three-Factor HJM Model (Nominal Rates, Real Rates and Inflation Index)

Nominal Forward Rates:

Real Forward Rates:

Inflation Index:

In Practice

Adjusted to incorporate Stochastic Volatility

Calibrate volatility assumptions as well as correlations between factors

Used to value Exotic (Path-dependent) Payoff Structures

34
* Pricing TIPS and Related Derivatives…: http://forum.johnson.cornell.edu/faculty/jarrow/084 Tips JFQA 2003.pdf
Black-Scholes Type Models

Option Pricing Models

Black’s Model: Treat Inflation Index as Log-normally Distributed

Bachelier Model: Treat Inflation Rate as Normally Distributed

Shifted Log-normal Model: Inflation Rate cannot go below -100%

In Practice

Intraday calculations for vanilla Inflation Options

e.g. TIPS Redemption Floors

Different volatilities by Term and Strike based on calibrations to market trading levels

35
SABR Model *
Incorporates Stochastic Volatility. SABR: Stochastic Alpha Beta Rho

Allows better fitting of Volatility Skews/Smiles

Process:

Alpha is the (log-normal) volatility of volatility - influences the Volatility Smile

Beta is the sensitivity of the change in forward to the level of the forward – influences the
Volatility Skew (e.g. normal vs. log-normal)

Rho is the correlation between the two processes i.e. the correlation between change in
Forward Level and change in Volatility – also influences the Volatility Skew

Generally, Beta is fixed based on historical experience, and Rho is calibrated

In Practice

Pricing of all vanilla inflation options, including daily mark-to-market of vanilla option books

Much quicker and more stable than JY Monte Carlo Model, but cannot value exotics
36
* Managing Smile Risk, P. Hagan et al., 2002: http://www.math.columbia.edu/~lrb/sabrAll.pdf
Inflation Market
Summary

Products
• TIPS Treasuries whose principal adjusts in-line with CPI
• TIPS Asset-Swap Obtain a yield pickup over treasuries / repo rates
• Inflation Swaps Hedge or take a view on inflation
• ETFs / ETNs Trade in a similar way to Equities
• Total Return Swaps Unfunded exposure to TIPS or TIPS Breakevens
• Inflation-linked Notes Customized inflation-linked cash flows
• Inflation Options Capped or floored exposure to inflation

Models
• Jarrow -Yildirim Exotic inflation options
• BS-Type Intraday calculations
• SABR Vanilla inflation option

Structural Imbalances in the Inflation Market

• Inflation Swaps imply higher CPI levels than TIPS
• Very front-end of the inflation curve tends to be cheap
• Implied volatility significantly exceeds realized volatility 37
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38