by Jeff Cooper, Diane Hirschberg and Steve Santa-Maria
BMO Capital Markets Foreign Exchange
Has the recent volatility within the financial markets become the “new-norm”, or are the global financial markets working to digest the recent European Debt Crisis and return to more normal historical levels? While that question can still be the impetus for a hotly contested debate, the one item that is not debatable is that with the global markets more intertwined than ever, what happens in Greece/Europe or any other geographic region will have an impact over a wide range of markets and geographies. If 2008 disproved anything it was the notion that a crisis can be contained and only have meaningful impact in one’s home. While the equity and bond markets gather headlines with regular market moves of 2, 3 and 4% daily since mid-July, the currency markets have been weathering similar volatility moves.
The FX market segregates currencies into categories: G10 – highly liquid, freely traded currencies of developed markets that have no restrictions with regards to delivery. Emerging market or EM currencies trade less and may have restrictions on deliverability, as well as controls by its local Central Bank which can impact market values. All of these currency markets, whether developed G10 or less developed EM, are susceptible to bouts of increased volatility. EUR/USD is the largest and most liquid FX currency pair and is the best proxy for overall G10 market volatility. We have recently seen another bout of extreme volatility in the FX markets with 3 month EUR/USD implied volatilities shooting up to the 15-17% area. Since December 2008 the volatility in 3 month EUR/USD has traded as high as 24.5% vs. 9.5% just 6 months earlier. Implied volatility measures the anticipated daily moves in the underlying currency for a certain period of time in the future. To put that in perspective, the market was anticipating a move of 0.1655 points over a 3 month period in December 2008 (24.5% volatility) vs. 0.0642 points just 6 months earlier (9.5% volatility).
While extreme volatility in currency moves is painful to corporate FX and asset managers it can also create interesting and unique hedging opportunities.
Here is a compelling example of using higher levels of volatility in the options market to create a better hedge for a seller of U.S. dollars / buyer of Canadian dollars:
For the past 6 years the average volatility for 3 month at-the-money (ATM) implied USD/CAD volatility has been about 11% and has ranged from a pre-crisis low of 5.8% to a high of 25% during the 2008 financial crisis. Current 3 month USD/CAD volatility is at 12.75%. Since the financial crisis the average 3 month implied USD/CAD volatility ratcheted up to about 13%. Not only have underlying option volatilities increased, but the difference between out-of-the-money (OTM) and ATM volatilities has also widened considerably. This difference between ATM options and lower delta options is referred to as the “skew”. The skew is the volatility difference between an ATM and an OTM option. During periods of extreme spot volatility and uncertainty, the move in the skew is a function of supply and demand for certain options, most evident through the pricing of “risk reversals” or calls vs. puts of the same delta.
Currently the options market is pricing Canadian dollar puts at higher volatilities than Canadian dollar calls. Since 2005 the average skew for 25 delta options has been roughly 0.5%, currently this skew is 4% (favoring CAD puts).
The combination of high implied volatility and the pronounced bid for CAD puts vs. CAD calls presents some appealing hedge opportunities for USD sellers.
Collars (zero cost) are a popular hedging strategy and the high risk reversal creates an opportunity to construct collars that take advantage of this factor. For example, with spot at 1.0300, the 3 month forward at 1.0320 and the 3 month vol at 12.7, a collar protecting 1.0000 would have a corresponding CAD put of 1.0660 with no skew priced in. This would be almost symmetrical around the forward; 0.0320 point give up vs. the forward compared to a 0.0344 point benefit. However, by taking advantage of the elevated demand for CAD puts, which the hedger is selling, the collar would come in at 1.0000 – 1.0809. The benefit level has increased to 0.0489 points, giving the collar a 0.0169 advantage over the collar with no skew. To the hedger, the fact that the market is “bidding up” the risk reversal has no bearing on the protection level but does present an opportunity to take advantage and gain a desirable hedge position.
Hedgers may also be able to positively utilize extreme levels of volatility when constructing a hedge by selling the volatility and having that “short-volatility” position embedded into their hedge. The hedge will have clearly defined points of protection and participation but by selling the volatility at historically high levels, the value of that volatility can be used to tilt the symmetrical nature of the hedge in the hedger’s favor. For example: a variation on the collar modeled after a Forward Extra trade can be used to gain much of the advantage of the collar in addition to selling the high volatility. The hedger can buy the same 3 month 1.0000 protection (CAD call) and sell a 1.0600 CAD put that only knocks in if spot USD/CAD trades at 1.1600 at any time during the life of the option (zero cost). The hedger has not only taken advantage of the high skew but also the high level of volatility. If volatility and the risk reversal had been closer to historical norms of 11% and 0.5% for CAD puts respectively, the barrier would be 1.0900 in order to enter the hedge at zero cost. This hedge allows the hedger a best case rate of 1.1599, a benefit of 0.1279 points over the forward, while only ‘costing’ 0.0209 points of give up over the regular collar.
Many times volatility and skew can be important factors in implementing attractive hedges, and can, as the above strategies illustrate, give hedgers a significantly more advantageous risk/reward scenario. Savvy hedgers should be asking their FX banks for ideas that incorporate these advantages. ~
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