The dollar may be dropping in the spot market, but in options world… it’s still going strong.
The option market skew in dollar crosses — the difference between the implied volatility of out-of-the-money dollar-related puts and calls – remains bid towards dollar appreciation. And Goldman Sachs figures that the “puzzling” dollar skew can be explained by cross asset hedging, in a piece of research out on Wednesday.
To understand you need to float back in time a bit — all the way to October 2009:
For cross asset correlations with the Dollar, October 2009 was a very important month. Admittedly, it was also the month when the previous Greek government lost the elections and it became gradually clear that the fiscal situation was in worse shape than previously thought. But to be fair, it took a few additional months for this information to become a dominating market driver.
However, and more importantly, October 2009 was also the first month where it became clear that the risky asset recovery from the abyss of the credit crisis would not be a one-way street. Within the month the SPX rallied by more than 70 points to about 1100 only to drop back towards 1030 by the end. For the first time since equity markets had seen the trough, the steady decline in implied equity market volatility took a breather, too. The VIX index made a brief new local high above 30 after having already spent about 4 months clearly below this level.
Something else happened in October 2009. The correction in equity markets went hand-in-hand with similar moves across a whole range of asset classes. In particular a number of FX crosses matched the equity moves like a carbon copy.
Place yourself in the shoes of a risk manager then.
As Risk Magazine wrote earlier this year; “it’s a risk management truism that the most reliable hedge will match an exposure like-for-like – equity with equity or credit with credit. It’s also true that these hedges will be most expensive when they’re most needed.” With sovereign spreads widening and equity markets falling, you might be looking for a new type of hedge — one that’s not necessarily like-for-like but acts the same way in that (ultra-correlated) environment. According to Goldman the correlation in daily returns over a three-month window between the S&P 500 and the bank’s trade-weighted US Dollar index rose to a massive more-than-60 per cent (negatively correlated) in October 2009.
So look at something like the euro/dollar skew. You might figure that investors will want to buy more euro puts as the eurozone debt crisis intensifies, so you load up on so-called ‘risk reversals’ — a bought put and a sold call. Et voilà, the skew in the euro/dollar option market intensifies. According to Risk euro/dollar risk reversals moved between a negative skew of -1.15 and -3.57 last year.
Back to Goldman:
The current situation is still dominated by a notable option market skew in favour of Dollar appreciation. When looking at the EUR alone it is tempting to conclude that part of this reflects continued sovereign concerns. While we believe this to be partly the case, it is also important to recognise that many other Dollar crosses also still display a similar skew. This in turn suggests that FX option markets continue to be influence by cross asset hedging flows. What is particularly interesting is the fact that the Dollar positive skew in option markets persists despite the Dollar currently experiencing one of the most pronounced periods of broad weakness in recent years. In particular at a time where sovereign debt concerns gradually shift from the Eurozone to the US, it is thinkable that weakness in risky assets becomes associated with Dollar weakness at the same time. Such a scenario would obviously go against recent correlation patterns and raise the question if owning Dollar calls really is an attractive proxy hedge for risky assets.
Quite a big change, if it happens.
Related links:
Risk managers search for eurozone defences - Risk
Nomura calls the end of risk on/risk off – FT Alphaville
‘A new era of Treasury price volatility’ – FT Alphaville
The new volatility FX carry trade – FT Alphaville