master class: return of volatility to the fx markets

Master Class:

Return of Volatility to the

FX Markets

Annie Grebenyuk | Francesco Tonin FX Market Specialists

Central Banks Balance Sheet Expansion - ECWB<GO>

GDP forecast comparison for G10 economies - ECFC<GO>

The size of the ECB balance sheet – BI LTRO<GO>

The size of the Fed balance sheet – BI BANKN HILID<GO>

The surge in FX volatility – VCA<GO>

The increase in Implied - Realised vol spread – WCRS<GO>

The change in FX volatility – VOLC<GO>

AUD/USD Volatility Smile Lower – OVDV<GO>

Possibility of next rate cut by RBA – WIRP<GO>

Demand for EURUSD calendar spread – GP<GO>

The change in steepness in EURUSD vol curve – XCRV<GO>

The change in spot vs RR correlation – VOLC<GO>

The recent change in favour of USD calls – VCA<GO>

• Volatility across the world has increased over the past six months

THE GREAT MODERATION IS OVER WVOL

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• JPMorgan vol index and EUR and JPY 3M volatility

THE GREAT MODERATION IS OVER JPMVXYGL INDEX

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• JPMorgan vol index and EUR and JPY 3M volatility, long term

THE GREAT MODERATION JPMVXYGL INDEX

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• Collapse in commodity prices

FACTORS BEHIND 2015 VOLATILITY CL1 COMDTY

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• De-peg of EURCHF: • Global event? No

• Orderly market? No • How to prepare and profit from it?

• Can you trade it after the de-peg?

FACTORS BEHIND 2015 VOLATILITY EURCHF CURNCY GIP

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• The Sharpe ratio of the FX carry trade declined during the second half of 2014

EFFECT OF VOL ON THE CARRY TRADE WCRS

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• Returns were similar six months ago, but the realized volatility was half as high

EFFECT OF VOL ON THE CARRY TRADE WCRS

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Much higher realized volatility over the last six

months vs. a year ago

• The carry trade suffered dramatically during Q4 2014

CARRY TRADE PERFORMANCE FXSW

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SIMILAR HISTORICAL PERIODS VOLC

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Taper Tantrum

Second Greek Crisis

First Greek Crisis

Euro Sovereign Crisis Starts

2008 Financial Crisis

SIMILAR HISTORICAL PERIODS VOLC

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Taper Tantrum

Second Greek Crisis

USD Debt Downgrade & First Greek Crisis

Euro Sovereign Crisis Starts

2008 Financial Crisis

Earthquake

Three Arrows Economic Policy

SIMILAR HISTORICAL PERIODS VOLC

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Taper Tantrum

Second Greek Crisis

USD Debt Downgrade, USDBRL, USDIDR Jitters & First Greek Crisis

Euro Sovereign Crisis Starts

2008 Financial Crisis

Earthquake in Japan

SIMILAR HISTORICAL PERIODS OVDV FOR EURUSD

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Current Market Taper Tantrum

Q3 2011 2008 Financial Crisis

Very flat vol term structure

SIMILAR HISTORICAL PERIODS VOLC FOR EURUSD

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• The risk reversal is at very elevated levels (bid for EUR puts)

RATIO 25DELTA EUR PUT / ATMF CIX

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Before the Financial Crisis

EURUSD RR is not very interesting

Start of the Euro Sovereign Crisis

Greek Bailout Taper Tantrum

SIMILAR HISTORICAL PERIODS OVDV FOR USDBRL

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Current Market Taper Tantrum

Q3 2011 2008 Financial Crisis

Very flat vol term structure

SIMILAR HISTORICAL PERIODS VOLC FOR USDBRL

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• The risk reversal is at quite tame levels despite spot performance

RATIO 25DELTA BRL PUT / ATMF CIX

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2008 Financial Crisis

The hayday of the skew

Relative Cheapness of Tail Risk

SELL THE SKEW IN USDBRL OVML

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• Backtesting of 3m ATMF vs 25D USD call spread in USDBRL

SELL THE SKEW IN USDBRL CONTROL GROUP OVML

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• Backtesting of buying 3m ATMF Straddle vs selling 3m 25D Strangle in USDBRL

• Factors that played a role in the classic definition of the great moderation

• Reduction in the volatility of real economy indicators

• Central banks control financial asset prices but not directly the real economy

• Urban myths

• The Fed creates asset bubbles

• Bubbles burst and volatility rises

• Tail risk insurance is a good deal

• Factors that are playing a role this time

• Real wars: Russia, ISIS

• Currency wars: ECO, BoJ

• One-time shocks: EURCHF, USDARS

• Significant vol rise across the market

• Volatility curves showing long term high vol trends

• Higher price of risk in EURUSD / Lower price of risk in USDBRL

FINAL CONSIDERATIONS

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