Option Butterfly Signals Investors Underestimate Currency Volatility Risk
Currency derivatives suggest investors are underestimating the risk of broad swings in foreign-exchange markets as the Federal Reserve completes its bond-purchase program and lawmakers spar over the U.S. debt limit, according to Bank of America Corp., JPMorgan Chase & Co. and UBS AG.
“You are looking at a massive event risk coming up, and the options market is underestimating that,” said David Woo, head of global rates and currencies research at Bank of America Merrill Lynch in New York. “These two issues could interact in very unexpected ways and become a major source of volatility in the markets.”
A gauge of the demand for hedges against extreme currency moves in the dollar against the euro, known as the option butterfly, is near the lowest since September 2008. Implied volatility of options that protect against fluctuations in developed nations’ currencies is 11.93 percent, below the record level of 26.55 percent set in October 2008 and an average of 12.5 percent the last two years, according to a JPMorgan index.
Option volatility for U.S. equities is also near a four- year low and at the least in almost a year for interest rates as the Fed drives investors to higher yielding assets by keeping borrowing costs at a record low while the Obama administration runs record deficits to sustain the recovery from the worst recession since the Great Depression. The Fed is scheduled to complete $600 billion in purchases of Treasury securities in June and the Treasury projects that the U.S. can borrow through Aug. 2 after reaching its $14.3 trillion debt later this month.
Euro Option Strangle
Bank of America’s Woo advised investors on April 26 to buy so-called U.S. dollar volatility if levels fall further by purchasing six-month euro option strangles. The strategy, which involves the simultaneous purchase of a euro put at a strike price of $1.374 and call struck at $1.547, will profit if the euro moves sharply during the life of the contracts. A call option grants the right to purchase a currency and a put allows for sales, with the strike price giving the pre-set exchange rate.
The dollar fell to a 17-month low against the euro yesterday on speculation the Fed will maintain record-low rates while the European Central Bank increases borrowing costs. The euro slid today after ECB President Jean-Claude Trichet said inflation risks will be watched “very closely,” signaling the policy makers may wait until after June to raise rates again.
The euro dropped 1.1 percent to $1.4666 at 9:58 a.m. in New York, after reaching $1.4940 yesterday.
‘End of QE’
Standard & Poor’s said on April 18 that the U.S. government risks losing its top rating unless policy makers agree on a plan by 2013 to reduce deficits and the national debt. The ratings company added that it saw a one-in-three likelihood of a reduction in the long-term rating within two years.
“The end of QE is likely to be more challenging for markets than the consensus assumes,” Mansoor Mohi-uddin, the Singapore-based head of global currency strategy at UBS said in an e-mailed response to questions. “We also have plenty of event risk in the eurozone as well as uncertainty about the direction of U.K. monetary policy and renewed intervention risks in Japan if the yen continues to rebound.”
The yen strengthened, falling below 80 per dollar today for the first time since central banks intervened to weaken the currency in March, on demand for the safest assets.
Low Volatility Environment
“Currency volatility could go lower,” said Caio Natividade, the London-based head of foreign-exchange derivative strategy for Deutsche Bank AG, said in a telephone interview. “Most news that should have shocked the market this year has not managed to do so for sufficiently long to make volatility rise sustainably. Our analytical models tell us that we are indeed moving to a low volatility environment again.”
Fed policy makers said at the completion of their rate- setting meeting on April 27 that the economy is recovering at a “moderate pace” and a pickup in inflation is likely to be temporary. The central bank kept rates locked at a record low of zero to 0.25 percent since December 2008.
Crude oil surged about 30 percent in the past six months in New York amid the threat of supply cuts. Gold and silver reached records in April as investors sought to hedge financial assets against a weakening dollar and accelerating inflation.
“Potential for disruptive gridlock in the U.S. budget debate combined with high oil prices and unrest in the Middle East presents tail-risks for the currency market,” said Arindam Sandilya, head of foreign exchange derivative strategy at JPMorgan in New York. “There is significant potential for shocks to the system that currency volatility levels suggest the market is not prepared for.”
To contact the reporters on this story: Liz McCormick in New York at emccormick7@bloomberg.net
To contact the editor responsible for this story: Dave Liedtka at dliedtka@bloomberg.net
Rate this Page