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We estimate that it is in 3yly, 2y2y and 2y1y that the selloff would be largest (75-85bp — see Table 5) were the OIS curve to align with the median dots up to end of 2019. Options are attractive to position for a selloff in those forwards for two main reasons: 1. Volatilities in ly and 2y tails appear to trade cheap on our macro model. More specifically, accounting for the relationship between implied vols and the first three principal components of the swap curve, we find that 2y1y implied vol should be trading 22bp normal higher (Chart 52), and 2y2y vol should be 19bp higher. A simpler historical regression of 2y1ly vol vs the 2y1y forward rate also suggests normal vol should be around 21bp higher (Chart 53). 2. Payer skews could richen in 2yly and 2y2y. While they are looking rich across 6M+ expiries in ly and 2y tails (based on payer-ladder breakevens/ATM vol}, we note that this has been the case for some time now and it’s rather in gamma on 5y+ tails that skews now appear richest on a 6m z-score basis. Relative to what has been realized in the past month, the payer skew appears just fair in 2y1y, while it is rich across tails in longer expiries. Chart 52: Market vs fitted level of 2y1y vol, based on macro model (*) Chart 53: 2y1y implied vol is 21bp too low on a regression vs 2y1y fwd 120 140 100 120 80 100 60 80 60 y = 35.017x + 28.016 40 R? = 0.8667 96 ——2y1y market implied vol 40 == 2y'y fitted 0 20 TUNA ANMYMMMTH TTT ONOMWNMNMOWO OO oO 0.5 1 1.5 2 2.5 3 &8 3 ES &8 5S E ge 2 5 & 8 s 3 &8 s 3 g = past 6y ¢ — since July m@ last Linear (past 6y) Source: BofA Merrill Lynch Global Research. (*) Based on a regression of log(2y1y vol) on the first three principal components of log of rates (derived with a PCA ran since Sep1 1). Rsquare = 0.97 Source: BofA Merrill Lynch Global Research Another way to look at this trade is through an analysis of payout ratios for 25-delta OTM payers under the scenario of a convergence towards median dots. Table 3 below confirms that the 2y1y point is attractive relative to other forwards (2 best), with a net payout ratio of 1.9 (2.9:1 gross) after three months. The best payer on that metric is the 3m5y 25-delta OTM payer (strike of 2.05%}, which we recommend as an alternative for those confident that the repricing of the OIS curve to the dots will take place by Feb-17. Table 3: Payoff ratios when buying a 25-delta OTM payer, under the selloff scenario where forwards converge to the levels implied by the median Fed dots(*) Trade Smty 3m2y 3m5y Sm10y 6miy 6m2y 6md5y 6m10y tyty Ty2y ty5y 1y10y 2yty 2y2y 2y5y 2y10y dsyty Sy2y Sy5y 3y10y Strike (25-delta), % 1.31 1.54 2.05 2.44 1.49 1.73 2.23 2.60 1.84 2.08 2.51 2.84 2.50 2.65 2.95 3.21 2.98 3.08 3.28 3.47 ATM forw ard, % 1.14 1.34 1.77 2.13 1.24 1.43 1.83 2.17 1.44 1.62 1.96 2.25 1.81 1.92 2.17 2.38 2.04 2.12 2.32 2.47 Premium, bp of yield 4.1 4.9 6.9 7A 65 75 9.6 10.0 10.4 Niles: 13.4 14.1 17.0 18.5 19.2 19.6 23.8 24.2 23.8 23.8 3mroll, bp of yield -4.1 -49 -6.9 -74 -5.1 -5.4 -5.9 -5.4 -5.0 -5.0 -4.3 -4.2 -44 -43 -3.3 -2.8 -3.5 -3.2 -2.6 -2.2 3m selloff to the dots fA 31 <2] 48 18 30 54 45 39 58 65 45 75 80 65 45 85 74 aif 45 Return, bp of yield -4.1 -44 16.5 5.4 -0.6 3.8 16.0 10.7 oe) 21.3 24.8 13.2 32.6 35.1 26.4 16.3 39.6 3o5 24.2 18.3 Net payout ratio -1.00 -0.89 0.73 -0.10 0.51 1.66 1.08 0.90 1.85 1.85 0.94 1.37 0.83 1.66 1.39 1.01 0.77 Source: BofA Merrill Lynch Global Research. Data as of 15-Nov. (*) 3m selloff to the dots = the selloff in the different forward OIS if the OIS curve aligns with median dots up to Dec-19, with a flat rate of 2.5% thereafter. The risk to the 2yly and 3m5y trades is a rally and/or decline in implied volatility, i-e., the reversal of the selloff recorded since the elections. Bank of America Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 29 Merrill Lynch HOUSE_OVERSIGHT_014759