One-month at-the-money EURUSD volatilities traded as high as 16%, up from 12% last week, following PMI data that indicated the eurozone may be entering a recession. That widened the gap with a group of eastern European cross rates. EURPLN vols were recently trading at 12.5% from 11.5% the previous week, while EURCZK vols rose only modestly to 6.78%, having traded between 5.20% and 6.15% over the past three months.
According to Saravelos, option markets are showing characteristics of dislocation because eastern European volatilities don’t reflect the potential risks to the region should the financial crisis in European deepen. “EURUSD is pricing in risks of outright disorderly developments, but this is not being priced into some parts of Eastern Europe and hence is a dislocation,” says Saravelos.
It’s not a view shared by everyone. Some analysts argue that the low implied vols in currencies like the Czech koruna reflect the country’s robust balance sheet and low reliance on eurozone credit lines that make it well insulated to the problems in the Europe.
“Net foreign assets in Czech are lowest in the whole region and the need for constant inflow of FX isn’t needed to maintain the balance sheet afloat as there is in countries like Poland and Hungary,” says Piotr Chwiejczak, an emerging markets FX strategist at Barclays Capital in London.
Furthermore, Chwiejczak argues, the risk of a big outflow of capital, should eurozone risks worsen, is unlikely to be acute because the country didn’t experience the large inflow that other CEE countries did following the 2008 financial crisis.
While Saravelos acknowledges that Czech Koruna benefits from stronger fundamentals, he says the economy is far from immune to a eurozone blow-up. A worsening of the economic situation in Europe would soon see the nation lose its status as the safe haven of eastern Europe because of its geographical location and trading relationship with Germany, where almost a third of its exports go.
“The Czech economy is hugely reliant on German; in the event of an outright crisis in the eurozone, the Czech economy would still be vulnerable, as it’s right next to Europe,” he says.
Saravelos recommends that FX investors look to exploit such disparities in the options market to hedge the tail risk of a full-blown crisis in Europe. With EURUSD implied volatility appearing too high, while EURCZK too low, one way to benefit from this disparity would be to buy double no touches in EURUSD on a two-month basis, and hedge that by buying implied volatility in EURCZK, which will likely rise if the eurozone crisis worsens.