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FX Market Update

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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, 13:50 GMT