Tuesday, May 18, 2010

The European Crisis Explained and Currency Option Trading

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I will examine five currency pairs (Euro, British Pound, Canadian Dollar, Australian Dollar and the Yen to the USD) and discuss the Greek (and rest of Europe) financial trouble in the context of background and trading/hedging opportunities.

The LIVEVOL Pro Summaries for the five FX pairs (these are ISE FX options) are below. Note that FX option vol is down across the board today.

First, a very quick background
The Treaty of Maastricht (formally, the Treaty on European Union) was signed on 7 February 1992 by the members of the European Community in Maastricht, the Netherlands. Amongst other things, it created the rules (requirements) for joining the European Union (i.e. the Euro).

By amalgamating these currencies, countries like Spain, Portugal, Italy and Greece, which were traditionally agricultural economies, are now able to borrow money with the same terms as the highly efficient and industrialized economies (i.e. Germany).

The requirements to enter the EU were focused around debt, inflation and trade. Greece did not meet the requirements, but never fear, Goldman Sachs to the rescue. In a billion Euro swap using the Japanese Yen, Greece was able to "move" (read: hide) debt off the books and allow it to conform to Euro requirements. In fairness to Goldman, Greece and the EU were highly motivated to make this happen, so while Goldman were the actual "arrangers", this thing was gonna happen almost no matter what (that's just my opinion).

Of course, no matter how you "arrange," reality strikes back. It's really no surprise to the open eyed that Greece is now in a huge amount of trouble. I understand that they now have worse debt ratios than Argentina and Russia when those countries defaulted (please verify this on your own).

For all you who think Greece is going to get "kicked-out" of the EU; in the words of the magic 8 ball, "Signs point to no." The extrication of a country is almost impossible, and the implication for the future is an even greater deterrent.

Keep in mind that Germany's geo-political clout stems from the EU existing and growing, without it, they're just Germany, with it, they are Europe (is there any precedence to worry about that?... hmmm). The growing risk now is that Spain, Italy, Portugal, Romania, Hungary and a whole bunch more Eastern European countries are on the verge of similar calamities. FYI, some would consider my use of the word "risk" a vast under statement.

Further, there are now talks about a devaluation of the Pound Sterling (England). Ok, quick and dirty lesson over, onto trading and options markets. Click any of the images below to enlarge them.

Let's take a look at some skews and see what the option markets are implying. Start with EUU (Euro/USD).

The Skew chart illustrates that the downside vol (Euro going down relative to USD) is higher than the upside. For those of you new to FX skew, this is actually not normal (unlike stocks). FX skew is usually parabolic - i.e. even risk to up and down moves. Put simply, the option market is pricing in the risk of a downward move for the Euro (relative to USD) with high vol.

Now the British Pound Sterling (USD/Pound)

We see now an upward sloping skew. The option market implies greater risk to a volatile move upward for the USD relative to the pound. Note that this is the same implication as above - USD up relative to a European currency.

Now Canada and Australia.

More of the same. The options market is pricing more likelihood of upward moves in the USD relative to Canada and Australia.

Finally, a change of pace. The Japanese Yen (USD/Yen).

The skew chart illustrates a higher likelihood of a downward move in the USD relative to the Yen (i.e. stronger Yen to dollar).

Option market skews imply a strong dollar (move upward is more likely) versus the Euro, Pound, Australian and Canadian Dollars. The options markets imply a higher likelihood of a downward move for the USD relative to the Japanese yen.

From what we've scene, a Euro weakening due to collapsing economies generally throws the market into a tail spin. The skew charts show there is a risk of this happening again (continuing). If the market goes down, then vol usually goes up for stocks (and the indices).

With the information you have above, does a natural hedge develop using currencies? Can you sell vol and buy vol but have the same delta bet? Can you only by vol or only sell vol and have a neutral delta bet?

This is trade analysis, not a recommendation.

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  1. Can you construct an example of buying/selling vol in the scenarios you mentioned?

  2. Do you mean buying vol (or selling vol) and getting long or short the market?

  3. currency market vols are not attractive to trade unless one is involved at institutional volumes.

  4. I think the graphs explain it all!