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FX Market Update

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Recent moves in EUR/USD and EUR/CHF are out of sync with our short−term models

Wed, Nov 26 2008, 16:42 GMT
by Danske Research Team

Danske Bank A/S

• Spot moves since last week: On Thursday, the Swiss National Bank (SNB) took markets by surprise as it cut its target rate by 100 bps, causing EUR/CHF to appreciate 2%. Also, with equity markets tumbling, EUR/SEK reached all-time highs on Friday. Monday's agreement to bail-out Citigroup contributed to a general improvement in risk appetite, causing EUR/USD to appreciate to levels not seen since the beginning of November.

• Recent moves in EUR/USD and EUR/CHF are out of sync with our short-term models: Although the estimate has moved slightly upwards since last week, EUR/USD and EUR/CHF are now trading nearly four standard deviations above our short-term financial model. This potentially reflects that the currencies are not aligned with movements in other asset classes and that we could see a correction in the short term. Our forecasts are 1.21 and 1.46 respectively on a 3-month horizon.

• Skewed option-implied distribution in Scandies: Following last week's violent moves, particularly in EUR/SEK, and the accompanying rise in implied volatility, risk reversals in EUR/SEK and EUR/NOK have reached the highest levels since the introduction of the single currency. This translates into wide and skewed option implied distributions. For example, on a 3-month horizon the option implied 90% confidence region in EUR/SEK spans the interval [9.06; 11.74] with the spot at 10.27.

• Strategy: Although AUD/USD has fallen somewhat during the past week, it continues to mark one of the largest deviations from our short-term financial models (STFM). While we acknowledge the large depreciation already seen in AUD against USD (35% since mid-July), we believe that the cocktail of a global recession and continued financial distress could send the pair somewhat lower. For example, one way to position for a limited fall in AUD/USD would be through a 1-month reverse knock-out put-option (spot reference 0.635, strike 0.64, barrier 0.565). Given the very negative risk reversal, this comes at a low price of 110 AUD pips; a comparable vanilla put costs around 310 AUD pips (indicative prices only).

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Published on  Wed, Nov 26 2008, 16:42 GMT

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FX Market Update

Tue, Nov 18 2008, 13:46 GMT
by Danske Research Team

Danske Bank A/S

• Spot moves since last week: Following the Bank of England's (BoE's) very dovish inflation report, EUR/GBP gained over 3% during the past week. From the perspective of the short-run financial model, the upward move seemed overdone with the estimate unchanged at 0.83. Big spot moves were also seen in the dollar-block, with CAD, AUD and NZD continuing to lose ground (2-4%) against the US dollar. According to our short-term financial models, these moves can be explained by the further fall in the price of oil (down USD6/barrel since last week) and a decline in world equity prices.

• Interest rate correlations very low: Except for GBP, CHF and JPY, the correlation between FX and interest rates is very low. Rather, the currency pairs seem to correlate with equities and commodities, possibly reflecting a weakening of the correlation with fixed income markets as deleveraging continues.

• Sharp increase in EUR/GBP implied volatility and risk reversal: Implied volatilities increased in most currency pairs, especially in EUR/GBP, reflecting high realised volatility. At the same time, the EUR/GBP risk reversal jumped to the highest level seen in five years. The situation bears some resemblance to what happened at the beginning of this year, as the risk reversal spiked following a large upward spot move and subsequently fell. However, we still see short-term risks for EUR/GBP on the upside.

• Strategy: Since last week the euro has strengthened close to 2% against the Swiss franc, despite further equity losses. Also, EUR/CHF trades more than 3 standard deviations above the short-term financial model estimate, underlining what seems to be a misalignment relative to other asset classes. One way to position for a fall in EUR/CHF, which is not driven by a new blow-up in the financial crisis (i.e. implied volatility remain contained), would be through a reverse knock-out put-option with the barrier placed just below a support level (two-week maturity, strike 1.51, barrier 1.44). Given the extreme risk reversal, this comes at a low price of CHF105 pips relative to the vanilla (CHF190 pips - indicative prices only), meaning that the breakeven is just below 1.5.

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Published on  Tue, Nov 18 2008, 13:46 GMT

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FX Market Update

Tue, Nov 4 2008, 17:28 GMT
by Danske Research Team

Danske Bank A/S

• • The past week's best performers were the currencies of commodity exporting countries. Against USD, CAD rose by nearly 7%, which despite the increase in oil seems slightly overdone from the perspective of our short-term financial models. 

• • Turning to AUD/USD, which rose by around 4% during the past week, the recovery in world equities has been an important driver. Nevertheless, the current level of the spot is significantly above the model's estimate, perhaps indicating that the recent move is due to an improvement in risk appetite rather than changes in the underlying financial drivers.

• • In the last edition of FX Market Update, USD/JPY marked one of the largest deviations between the spot and our short-term financial model. However, USD/JPY has since strengthened, thereby closing the gap to the model estimate.

• • Due to the relief rally in risky assets, the fall in implied volatilities comes as no surprise. Implied volatility in USD/CAD has increased since last week but has fallen in recent days. Nevertheless, implied volatility remains high by historical standards, which translates into wide confidence regions for most currency pairs. In some pairs, the confidence regions are particularly skewed, reflecting extreme risk reversals. For example, in USD/JPY the option market prices a 90% probability of the spot trading within the interval [76.64; 109.82] on a 3-month horizon and [61.01; 112.86] on a 1-year horizon.

• • One way of taking advantage of high implied volatilities, while avoiding the unbounded downside risk of a short strangle or straddle, would be through no-touch, or European digital options. For example, these strategies could be implemented in EUR/GBP which has been trading in a range since March this year.

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Published on  Tue, Nov 4 2008, 17:28 GMT

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FX Market Update

Tue, Oct 28 2008, 15:59 GMT
by Danske Research Team

Danske Bank A/S

Highlights of this week's FX Market Update:

• • During the past week, financial deleveraging continued and showed its effect not least on the currency market. Simultaneously, Brent crude oil fell 15% whereas equities (MSCI World) lost 16%. Turning to our short-term financial models, we can thus quantify recent drivers of EUR/USD. According to the model, equities have driven the estimate 5 big figures lower whereas the weakening of the oil price has led to a further fall of 2 big figures. The model’s estimate is currently 1.21. 

• • One week ago, our short-term financial model indicated that EUR/CHF was trading at high levels compared to underlying financial drivers (>3 std.dev. above the model estimate). However, the last week saw EUR weaken substantially against CHF, thus approaching our model estimate. This week's poor performance of equities has caused the model estimate to fall by another 5 big figures (currently 1.43). 

• • In EUR/SEK, the model estimate has seen a large increase from 9.68 to 9.99 and is now on a par with the spot. The change was mainly driven by the fall in equities in general and Swedish equities in particular.

• • Given the large moves witnessed in the currency market over the past week and lack of risk appetite, it is not too surprising that implied volatilities have reached new all-time highs in many currency pairs. However, realised volatility is elevated as well and in some pairs the spreads between realised and implied are historically low, e.g. AUD/USD and NZD/USD. 

• • Risk reversals have reached extreme levels in many currency pairs. In particular, the USD/JPY risk reversal is at an all-time low of -9.7, indicating that puts trade at a massive premium relative to calls.

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Published on  Tue, Oct 28 2008, 15:59 GMT

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FX Market Update

Wed, Oct 15 2008, 16:36 GMT
by Danske Research Team

Danske Bank A/S

Today we are launching our new weekly publication, FX Market Update, which provides a handy overview of the currency market. For each of nine currency pairs, key information is shown including our short-term financial models, option implied distributions and volatility data.

Highlights of this week's FX Market Update:

• • Over the past month, the fall in equities, the lower oil price and a narrowing of relative interest rates have been vital in driving the short-term financial model prediction of EUR/USD lower. This week's turnaround in equity markets and decline in oil prices have raised the fair-value estimate for EUR/USD from 1.28 to 1.31. 

• • The largest deviations from our short-term financial models are AUD/USD and NZD/USD, which are both trading well above the fair value estimates. The models indicate fair values around 0.67 and 0.57 respectively, primarily driven by the poor performance of equities over the past month. 

• • Following the proposal of measures by governments around the world to address the financial crisis, implied volatilities have come down for all currency pairs in recent days, although implied volatilities for all pairs except USD/JPY and EUR/USD are still trading above the levels seen last week. 

• • Since last week, EUR/USD risk reversals have turned less negative, reflecting the stabilisation of the spot level around 1.36.

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Published on  Wed, Oct 15 2008, 16:36 GMT