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Foreign Exchange

Eurodollar overstating sovereign contagion risk, FX options indicate

The potential for a domino effect across the eurozone from the most recent Greek crisis, 12 months on from the last one, is playing out across the financial markets. Worries about sovereign contagion have spread across global markets already, with equity markets and commodity markets following the euro lower in recent weeks. Markets have become highly correlated again.

Indeed, the themes that have dominated the price action this month are very similar to the themes of May 2010 when concerns for the future of the euro led to a sharp depreciation and a rise in implied volatility. This month, the euro has almost replicated that move – falling from 1.4830 to the dollar on May 2 to a low of 1.4048 on May 23. However, implied volatility in the options market is relatively unchanged on the month.

Looking back at last May, as European leaders argued over a bailout solution for Greece, the euro took a pounding, dropping from about 1.3300 to below 1.2200 over that month. Implied volatility spiked, as markets looked for risk-aversion trades. Three-month ATM vols rose from about 12% in early May to 16% by the end of the month, and then continued higher to above 18% in June. Fast forward a year, and the theme and price action in the spot market isn’t too dissimilar, but price action in the options market is more benign. (see chart) Three-month implied vols rose in the early part of the month, from 11.70% to 13.25%, before trading lower again at around 12.75%. So what’s different this year?


 Euro/dollar implied ATM volatility vs. spot rate, H1 2010

 
White line: 3 month ATM implied vol; Brown line: euro/dollar spot rate
 
Source: Bloomberg data

 Euro/dollar implied ATM volatility vs. spot rate, H1 2011

 
White line: 3 month ATM implied vol; Brown line: euro/dollar spot rate

Source: Bloomberg data

“Last year the euro sell-off wasn’t priced in and the Greek problem wasn’t priced in like it is now,” says the head of option trading at a European bank. For instance, in the credit default swap markets Greece’s five-year CDS now trades at a record high of almost 1,500 basis points, up from about 890bp at the beginning of May last year. More broadly, the Markit iTraxx SovX Western Europe Index has almost doubled since May last year. “If you look at Greek CDS, the market has been pricing in big problems for a long time; the same is true of the implied vol market, so it’s just not a surprise to anybody this year, like it was last year,” another trader says. Moreover, there were other risks to contend with last year. For instance, currency intervention from the Swiss National Bank, which made the euro/swiss cross rate extremely volatile, and the UK parliamentary elections. “You’ve not has this big ‘risk off’ trade that we had last year,” one trader concludes.

That seems to be borne out in the strategies that clients are implementing this month. “Last year a lot of customers were just buying outright euro puts, dollar calls on the move lower, and when spot reached levels approaching 1.2500, they starting using reverse knock-outs (RKOs) and euro put spreads, that sort of thing,” says an option structurer at a European bank. Traders say that such structures are quite often very good indicators of the end of a large move in spot. What’s different this May is that clients have shown a preference for put spreads and RKOs at the very start of the move down, from the high of 1.4830, the option structurer adds.

Another trader points to the implied volatility levels. They are still pricing in some risk premium in the euro, and they remain above historical vol levels, but they’re not close to the overshooting of implied vol last year, when they were at times trading 5% above historical vols. “That’s usually when people are scrambling to cover risk that they have,” the trader says. 

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