Everything you wanted to know about FX volatility but were too afraid to ask

Simon Watkins
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Given monetary interventions since the financial crisis, FX volatilities have erred on the low side and should remain depressed, challenging easy FX profits. However, the risk premium in emerging market (EM) FX is now trading back in line with equities rather than G10 FX, presenting trading opportunities.

Before the financial crisis that began in 2007/08, the world’s central banks’ principal, and often sole, responsibility was price stability.

However, since then their remits have broadened out to include a range of socio-economic targets, such as employment levels, interest rates and inflation, challenging traditional FX strategies, says Marc Chandler, global head of currency strategy for Brown Brothers Harriman (BBH), in New York.

As a corollary of these, he adds, many of them, particularly those of G10, have been engaged in “smoothing operations” of FX volatility since the crisis, sometimes working in tandem. This explains why – even during the recent “mini blow-up” in EMs – the global Volatility Index (VIX) still only stood at around the 21 level (briefly), relative to its 20-year average of about 20.50, and indeed has spent most of this year trading below 13.

Jane Foley, senior FX strategist for Rabobank in London, says: “Across the G10 currencies as a whole, the past year has seen volatilities drop markedly, with one or two exceptions, so the opportunity to generate revenues for traders dropped significantly as a result.”

Having said this, there are still opportunities to ride momentum strategies on some volatility plays, both in the EM arena and in some developed markets too.

Eric Viloria, currency strategist for Wells Fargo in New York, says: “Part of the reason for the ongoing lower level of volatility in many of the developed markets (DM), especially those in G10, is the increased level of policy transparency in the adjunct countries through forward guidance, which has meant that the corollary currencies are less prone to policy shocks.

“However, in many of the emerging markets, there is less forward guidance, therefore less transparency, and therefore a greater propensity for increased volatility.”

This tendency towards greater volatility has been further compounded, he concludes, by the lower level of liquidity flows that has occurred in the past few months. This is partly as a consequence of tapering quantitative easing by the US Fed, reducing the pool of money looking for higher-yielding currencies, together with apparently improving economic prospects in a number of DM countries, causing a shift in sentiment to the detriment of the EM world. 

In this context, although EM FX and wider risk-appetite has stabilized in the past week after the recent large position liquidations, it is probably wise at this point to exercise caution over the near-term volatility in EM FX as an asset class, according to various analysts.

“Arguably, the re-correlation of EM FX volatility with equity volatility is a return to the pre-crisis period when EM was priced in line with riskier assets, rather than developed market currencies,” says Chris Walker, FX strategist at Barclays in London.

In fact, he adds, the pre-crisis implied volatility of high-carry EM FX was priced and consequently traded largely in line with implied equity volatility (see Period 1 of the chart below). 

However, after the crisis, and partly as a function of steady portfolio inflows (see Period 2 in the chart above), both the absolute level and the volatility of implied EM FX volatility declined closer to the levels seen in developed market FX. Effectively, the risk premium in EM FX was being priced closer to that of G10 FX rather than equities.

“The recent rise in EM FX volatility [see Period 3 in the chart above] may thus represent a normalization to the pre-crisis period when EM FX was generally priced as a riskier asset,” says Walker.

Indeed, the chart below shows this difference between levels of the VIX and high-yield EM FX (HYEMFX) volatility versus the difference between HYEMFX volatility and G10 FX volatility. 

Walker concludes: “The level of the latter – that is, the level of implied volatility in HYEMFX above G10 FX – volatility rose last summer and has drifted higher since, consistent with normalization, rather than spiking higher as it has done in crisis periods.

“So, amid a gradual withdrawal of global liquidity, EM FX volatility may remain at elevated, pre-crisis levels.”

It is not just region-specific political and economic developments that drive EM FX volatilities, with much of the trajectory coming from the DM world, which, in turn, will also drive volatilities in DM FX.

This week, for example, volatilities spiked notably ahead of Tuesday’s first semi-annual testimony of new US Federal Reserve chair Janet Yellen to the House Financial Services Committee, says Geoffrey Yu, FX strategist for UBS, in London.

“Unsurprisingly as well, cable volatilities for Wednesday expiry were even higher when the Bank of England was due to announce an overhaul of its forward-guidance framework, the first edition having been rendered obsolete by the faster-than-expected decline in the unemployment rate,” says Yu.