FxVolWeekly
24 - Dec - 2021
Six Month Risk Reversal Update (data up to Dec 17th)
Very weak positive correlation between AUDUSD and one-month AUD risk reversals but clear signs of being a good indicator of toppish price action. Taken alone the spot vol correlation is not enough reason to initiate a spot position but it can be combined with other indicators such as momentum to give a better picture of spot exhaustion.
One would expect with CADJPY a higher degree of negative correlation but over the full year comes out as nearly flat. Still, you can clearly see the inability of the risk reversal to make new highs in sympathy with the spot as a potential exhaustion signal.
The premium for EUR calls over has come roaring back - faster than the spot correction. This is likely a function of the deal flow by the corporate hedging community. It also may be a factor in why EURCAD gamma remained subdued for so long -- it was simply a reflection of the options dealers getting long options as EURCAD declined and as a result they became natural sellers of the short dates.
The turn up in the one-month EURCHF reversal could well be taken as a sign of a EURCHF bottom forming. Obviously, geopolitical tension will be the main factor in the direction of EURCHF, but we have to believe the Swiss National bank will be the last central bank to start any sort of monetary tightening process as real concerns about further CHF strength. A one-year at-the-money EUR calls CHF put would cost approx 200 points. So a long EUR short CHF position in the spot market would need a move to 200 points higher to break even.
Here too skew in EURGBP has come back bid for EUR calls and are now well off their lows.
Risk-off sentiment rose sharply in USDJPY and EURJPY following the news of the omicron variant. And just as quickly as the story has taken a more optimistic turn the premiums for yen calls has declined.
One month EUR risk reversals nearly back to flat. Still the risk reversal is not showing any clear signs of diverging from spot just yet.
GBPCAD risk reversals in the past year have been uncorrelated to the spot and divorced from GBPUSD risk reversals.
Similar spot vs RR divergence in the middle of the chart where the risk reversal tests the -0.50 level twice and when the spot makes fresh high later the risk reversal fails to rise again to the same degree.
Less clear signs of divergence with GBP but still the market does not trade through par (GBP calls over) despite the rise over 1.40. And you could argue that the spot round trip has left the skew still better bid for calls. The implication is that GBP weakness may be coming to an end.
Clear signs of spot vs risk reversal divergence in the middle of the chart with USDCAD making a low and the risk reversal unable to follow. The sensitivity of the skew to the spot is a strong indication of the degree of corporate/institutional-based hedging. However, if you have a look at the right-hand side of the chart you can see the risk reversal bottoming and then rising at the same time as the CAD continues to gain ground vs. the dollar. The take-away is that the divergence works some of the time but certainly not all the time and if you make directional bets based entirely on this indicator alone it is less likely to produce a positive trade, but still, it is worth considering alone with other indicators.
CHF like the yen is reacting with a sharp fall and retracement on the omicron news.
Yen showing the sharpest moves in reaction to the initial omicron variant news. No clear indication of spot vs risk reversal divergence in this case.
Better examples of spot risk reversal divergence can be seen in this chart of the MXN.
While risk reversals are often sold to the buy-side as costless in terms of the premiums, their real effective price is the skew. Banks simply fiddle with the vol spread and the stikes prices to equate the premium: the premium paid nets off against the premium received. However, the real cost of the trade is the skew - the price in vol terms, of out-of-the-money calls vs. the price of out of the money puts. It is surprising to what extent this is not fully appreciated. Of course, there are times when the skew is large and in your favour when you can set the stikes at equal deltas and get paid positive $$ to do the trade. For example, if you were a natural seller of yen calls and buyer of yen puts or a natural seller of MXN puts and buyer of MXN calls you would very likely be able to do the trade and realize the net difference in the final price of the option premiums. Or, you can vary the strikes in such a way as to widen the spread between the strikes in your favour. As we pointed out in earlier weeklies the decline in the one-year MXN risk reversal may well be a sign that hedgers are getting less worried about a sharp down move in the peso. While the bid in the premiums for CAD puts vs CAD calls both in USDCAD and EURCAD is a sign of persistent buy-side concern with the potential CAD downside risk. Often the risk reversal is bid over for the lower interest rate FX pair. For example, JPY is bid over in USDJPY, the USD is bid over in USDMXN, and CHF is bid over in EURCHF. In those cases when it does not apply it can sometimes be a sign of a market that is overbought. For example on those rare occasions when Yen puts trade at a vol premium to Yen call or CAD call trade at a premium to CAD puts. But as a directional indicator, it is not flawless for sure, and it should be taken as one indicator that should be considered in relation to other systematic tools.
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Research Director