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Volatility And The Fx Market – Utilizing Volatility To Your Advantage

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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. ~

To learn how BMO Capital Markets can help you achieve your ambitions, email us at [email protected], or visit www.bmocm.com/fx for a list of contacts in your area.

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Trading

Economic recovery likely to prove a ‘stuttering’ affair

Economic recovery likely to prove a ‘stuttering’ affair 1

By Rupert Thompson, Chief Investment Officer at Kingswood

Equity markets continued their upward trend last week, with global equities gaining 1.2% in local currency terms. Beneath the surface, however, the recovery has been a choppy affair of late. China and the technology sector, the big outperformers year-to-date, retreated last week whereas the UK and Europe, the laggards so far this year, led the gains.

As for US equities, they have re-tested, but so far failed to break above, their post-Covid high in early June and their end-2019 level. The recent choppiness of markets is not that surprising given they are being buffeted by a whole series of conflicting forces.

Developments regarding Covid-19 as ever remain absolutely critical and it is a mixture of bad and good news at the moment. There have been reports of encouraging early trial results for a new treatment and potential vaccine but infection rates continue to climb in the US. Reopening has now been halted or reversed in states accounting for 80% of the population.

We are a long way away from a complete lockdown being re-imposed and these moves are not expected to throw the economy back into reverse. But they do emphasise that the economic recovery, not only in the US but also elsewhere, is likely to prove a ‘stuttering’ affair.

Indeed, the May GDP numbers in the UK undid some of the optimism which had been building recently. Rather than bouncing 5% m/m in May as had been expected, GDP rose a more meagre 1.8% and remains a massive 24.5% below its pre-Covid level in February.

Even in China, where the recovery is now well underway, there is room for some caution. GDP rose a larger than expected 11.5% q/q in the second quarter and regained all of its decline the previous quarter. However, the bounce back is being led by manufacturing and public sector investment, and the recovery in retail sales is proving much more hesitant.

China is not just a focus of attention at the moment because its economy is leading the global upturn but because of the increasing tensions with Hong Kong, the US and UK. UK telecoms companies have now been banned from using Huawei’s 5G equipment in the future and the US is talking of imposing restrictions on Tik Tok, the Chinese social media platform. While this escalation is not as yet a major problem, it is a potential source of market volatility and another, albeit as yet relatively small, unwelcome drag on the global economy.

Government support will be critical over coming months and longer if the global recovery is to be sustained. This week will be crucial in this respect for Europe and the US. The EU, at the time of writing, is still engaged in a marathon four-day summit, trying to reach an agreement on an economic recovery fund.  As is almost always the case, a messy compromise will probably end up being hammered out.

An agreement will be positive but the difficulty in reaching it does highlight the underlying tensions in the EU which have far from gone away with the departure of the UK. Meanwhile in the US, the Democrats and Republicans will this week be engaged in their own battle over extending the government support schemes which would otherwise come to an end this month.

Most of these tensions and uncertainties are not going away any time soon. Markets face a choppy period over the summer and autumn with equities remaining at risk of a correction.

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Trading

European trading firms begin coming to terms with the new normal

European trading firms begin coming to terms with the new normal 2

By Terry Ewin, Vice President EMEA, IPC

In recent weeks, the phrase ‘never let a good crisis go to waste’ has received a large amount of usage. Management consultancies, industry associations and organisations, including the Organisation for Economic Co-operation and Development (OECD) have all used it in order to discuss how the current crisis, caused by the Coronavirus pandemic, presents an opportunity for new and worthwhile change.

The saying is also commonly used to indicate that the destruction and damage that is caused by a crisis gives organisations the chance to rebuild, and to do things that would not have previously been possible. This has the potential to impact financial trading firms, where projects that this time last year would not have made much sense now appearing to be as clear as day. In Europe, banks and brokers alike are beginning to think about what life will look like post-pandemic, and how their technology strategies may need changing.

We can think of three distinct phases when it comes to a crisis. Firstly, there is the emergency phase. This is followed by the transition period before we come to the post-crisis period.

Starting with the emergency phases, this is when firms are in critical crisis management mode. Plans are activated to ensure business continuity, and banks and brokers work to ensure critical functions can still take place so as to continue servicing their clients. With regards to the current crisis period, both large and small European banks and brokers were able to handle this phase relatively well, partly due to the fact that communications technology has reached the point where productive Work From Home (WFH) strategies are in place. For example, cloud-connectivity, in addition to the use of soft turrets for trading, has enabled traders from across the continent to keep working throughout lockdown. From our work with clients, we know that they were able to make a relatively smooth transition to WFH operations.

In relation to the current coronavirus crisis, we are in the second phase – the transition period. This is the stage when financial companies begin figuring out how best to manage the worst effects of the ongoing crisis, whilst planning longer-term changes for a post-crisis world. One thing to note with this phase, is that no one knows how long it will last. There is still so much we don’t know about this virus. As such, this has an impact on when it will be safe for businesses to operate in a similar way to how they were run in a pre-pandemic world. But with restrictions across Europe starting to be eased, there is an expectation that companies will start to slowly work their way towards more on-site trading. For example, banks are starting to look at hybrid operations, whereby traders come in a couple of times a week, and WFH for the rest of the week. This will result in fewer people in the office building, which makes it easier to practise social distancing. It also means that there is a continued reliance on the technology that enables people to WFH effectively.

Finally, we have the post-crisis period. In terms of the current crisis, this stage is very unlikely to occur until a vaccine has been developed and distributed to the masses. Although COVID-19 has caused mass economic disruption, many analysts are predicting a strong rebound once the medical pieces of the puzzles are put into place. It may not be entirely V-shaped, but the resiliency displayed by the financial markets thus far suggests that it will be healthy.

Currently, many European trading firms are taking what could be described as a two-pronged approach.

The first part of this consists of planning for the possibility of an extension to phase two. Medical experts have suggested that there could be some seasonality to the virus, with the threat of a second wave of COVID-19 cases in the Autumn meaning that the risk of new restrictions remains. If this comes to fruition, there would be a need for organisations to fine-tune their current WFH strategies and measures, and for them to take greater advantage of the cloud so as to power communications apps.

The second component consists of firms starting to think about the long-term needs of their trading systems. Simply put, they are preparing themselves for the third phase.

It is in this last sense, that the idea of never letting ‘a good crisis go to waste’ resonates most clearly.

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Trading

Currency movements and more: How Covid-19 has affected the financial markets

Currency movements and more: How Covid-19 has affected the financial markets 3

The COVID-19 pandemic has been more than a health crisis. With people forced to stay indoors and all but the most essential services stopped for multiple weeks, economies have suffered and financial markets have crashed. Perhaps the most public and spectacular fall from grace during the early stages of the pandemic was oil. With travel bans in place around the world and no one filling up at the pumps, the price of oil plummeted.

Prior to global lockdowns, US oil prices were trading at $18 per barrel. By mid-April, the value had dropped to -$38. The crash was not only a shocking demonstrating of COVID-19’s impact but the first time crude oil’s price had fallen below zero. A rebound was inevitable, and many traders were quick to take long positions, which meant futures prices remained high. However, with stocks piling up and demand sinking, trading prices suffered. Unsurprisingly, it’s not the only market that’s taken a knock since COVID-19 struck.

Financial Markets Fluctuate During Pandemic

Shares in major companies have dipped. The Institute for Fiscal Studies compiled a round-up of price movements for industries listed by the London Stock Exchange. Tourism and Leisure have seen share prices drop by more than 20%. Major airlines, including BA, EasyJet and Ryanair have all been forced to make redundancies in the wake of falling share prices. The automotive industry has also taken a knock, as have retailers, mining and the media. However, in among the dark, there have been some patches of light.

The forex market has been a mixed bag. As it always is, the US dollar has remained a strong investment option. With emerging markets feeling the strain, traders have poured their money into traditionally strong currency pairs like EUR/USD. Looking at the data, IG’s EUR/USD price charts show a sharp drop in mid-March from 1.14 to 1.07. However, after the initial shock of COVID-19 lockdowns, the currency pair has steadily increased in value back up to 1.12 (June 25, 2020). The dominance of the dollar has been seen as a cause for concern among some financial experts. In essence, the crisis has highlighted the world’s reliance on it.

Currency Movements Divide Economies

Currency movements and more: How Covid-19 has affected the financial markets 4

In any walk of life, a single point of authority is dangerous. Indeed, if reliance turns into overreliance, it can cause a supply issue (not enough dollars to go around. More significantly, it could cause a power shift that gives the US too much control over economic policies in other countries. Fortunately, other currencies have performed well during the pandemic. Alongside USD and EUR, the GBP has also shown a degree of strength throughout the crisis. However, these positive movements haven’t been shared by all currencies.

The South African rand took a 32% hit during the early stages of the pandemic, while the Mexican peso and Brazilian real dropped 24% and 23%, respectively. Like the forex market, other sectors have experienced contrasting fortunes. Yes, shares in airlines and automotive manufacturers have fallen, but food and drug retailers have seen stocks rise. In fact, at one point, orange juice was the top performer across multiple indices. With the health benefits of vitamin C a hot topic, futures prices for orange juice jump up by 30%. The sudden surge had analysts predicting 60% gains as we move into a post-COVID-19 world.

Looking Towards the Future through Financial Markets

The future is always unknown and, due to COVID-19, it’s more uncertain than ever. However, the financial markets do provide an indication of how things may change. The performance of USD and EUR in the forex markets suggest there could be a lot more trade deals negotiated between the US and Europe. The surge in orange juice futures suggest that health and wellness will become a much more important part of our lives. Even though it was already a multi-billion-dollar industry, the realisation that a virus can alter the face of humanity has given more people pause for thought.

Then, of course, there’s the move towards remote working and socially distance entertainment. From Zoom to Slack, more people will be working and playing from home in the coming years. The world is always changing, but recent have events have made us appreciate this fact more than ever. The financial markets aren’t a crystal ball, but they can offer a glimpse into what we can expect in a post-COVID-19 world.

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