There is no single measure of implied volatility for FX markets, unlike those that exist for the S&P500 or for US interest rates. To fill the gap, banks build their own proprietary indices, such as the JPMorgan global FX volatility index and Deutsche Bank’s Currency Volatility Index (CVix), using option pricing to measure implied volatility for certain currencies.
“There is value in this for various reasons, including understanding the probabilities behind the degree of price volatility expected in certain currencies, which may be useful for those needing to hedge,” says Joe Tuckey, head of FX analysis at Argentex, a London-listed currency broker. “For speculators, it can be a source of revenue generation – such as buying options when volatility is low for a subsequent increase in volatility, and vice versa.”
JPMorgan and Deutsche Bank declined to comment for this article.
Key characteristics of an index in any asset class is that it be both investable and transparent.
“In FX, this means that the underlying currencies are liquid and relevant and the index calculation is clear – whether using realised or implied volatility, a one-month or one-year time period, or equal or volume weighting,” says Ben Laidler, global markets strategist at trading platform eToro. Index construction differences can produce very different outcomes.
Whether investors are anticipating large fluctuations ahead of central bank rate changes or shifts from the political status quo, volatility indices allow market participants to plan ahead
Matthew Ryan, Ebury
For an active or dynamic currency manager, an index is a valuable tool in making decisions such as whether to hedge currency exposures.
“A manager might leave currencies unhedged if the carry is positive and the volatility index suggests low expected volatility, indicating a favourable risk-reward balance,” says Alex Dunegan, chief executive of Lumint Currency Management.
Keeping track of implied levels of currency volatility can allow traders to prepare for future swings in exchange rates that may have an outsized impact on bottom lines, says Matthew Ryan, head of market strategy at Ebury.
“Whether investors are anticipating large fluctuations ahead of central bank rate changes or shifts from the political status quo, volatility indices allow market participants to plan ahead by putting in place strategies to mitigate large market moves,” he says.
The alternative metric to implied volatility is realised volatility, which looks at the daily percentage changes in the exchange rate over a defined period and calculates the standard deviation of these returns, which are then annualised. But this is not always particularly relevant in FX.
“The shortfall of the classic realised volatility calculation is that FX traders typically trade ultra-short term, and while they do look at the daily percentage close-to-close price changes, they would trade moves within the full extent of a day’s high-to-low trading range,” says Chris Weston, head of research at Pepperstone, an FX broker. “So, measuring volatility from the daily trading range is a better gauge.”
Understanding index construction and the drivers of FX volatility is key – although FX volatility traders start with advantages in that volatility is a non-compounding asset and it is value range-bound, unlike the compounding behaviour of stocks, for example.
Multiple indices
Is it necessary for traders to review multiple indices to make the most of the data? Institutional FX traders do not always have long windows to get large positions executed since so much of their flow is related to security settlement, but FX volatility data can improve execution timing to some extent.
“If an FX trader has access to an index or one of the contributor composites they have an ear to the street, to give a soundtrack to what they are seeing in the spot and forward markets on a given day,” says Dunegan at Lumint.
When an FX volatility index is high, the market anticipates or is seeing a lot of movement, and protection from these movements is more expensive – with a direction needing additional interpretation.
“You need to understand that relationship for each currency cross comprising the index or have some view, hence some of our alpha strategies have a volatility factor in them,” explains Nathan Vurgest, director, head of trading at Record Financial Group. “On the other hand, one can look at trading FX option greeks [financial metrics like delta and gamma, which traders use to measure the factors that affect the price of an options contract] as there could be more opportunities in the option space.”
Agustin Mackinlay, analyst at Kantox, says his firm does not advise paying excessive attention to FX volatility indices, although it does recognise some possible uses by corporate risk managers, including setting FX mark-ups.
“The mark-up that is set in reference to the spot rate, when constructing the budget rate used in pricing, can be derived by looking at FX volatility indices,” he says.
Barometers and benchmarks
Most indices are used as barometers of market-risk perception, although it would not be difficult to use them as benchmarks for pricing derivatives to take views on volatility. In a volatility swap, the buyer of volatility pays the current rate on an index like the CVix and then receives the weighted average realised volatility of the basket of pairs within it.
“I don’t know if this actually takes place, but it probably wouldn’t be that difficult to structure,” suggests Tim Graf, head of macro strategy for Europe, Middle East and Africa at State Street Global Markets. “As far as whether it is necessary to review multiple indices, the short answer is: not really. They all basically tell you the same information, though it is interesting to look at differences between developed and emerging-market volatility as they are priced at different levels and can occasionally move independently.”
Tuckey at Argentex agrees that currency-volatility indices will generally follow a similar path, given the derivatives from which they generate their data.
The time horizon is an additional dimension to factor into calculations when gauging currency risk.
“When important economic or political events are coming up, the expected volatility in the short term usually exceeds the long-term rate, which is referred to as volatility inversion,” says Boris Kovacevic, global macro strategist at Convera. “It can give us hints about what events markets perceive to be important and is a key metric to watch in order to not overpay for currency protection in the short term.”
As a currency manager covering a lot of different things in FX, Record Financial does not have a focus on FX volatility indices from a day-to-day operational or trading perspective, says Vurgest.
“However, from a research perspective, market volatility measures could be a useful market characteristic and model input,” he says.
