Volatility: The strange case of back end vols – Deutsche Bank

Sebastien Galy, Macro Strategist at Deutsche Bank suggests that the back end implied volatility offers a surprisingly cheap source of funding as it is distorted by corporate selling.

Key Quotes

“In addition, running carry trades by selling longerdated volatility and buying short-dated ones offers most of the time a decent risk reward. Finally, as carry trades are run across assets, shocks in one propagate to others so that hybrid trades may be of some interest to take advantage of distortions or to hedge.”

“Running down the term structure

• A long position in the back end of the volatility term structure leaves you with a negative theta position that can be mitigated or modulated by owning the front end volatility. As the back-end implied volatility comes closer to maturity, so does the front end, so that only the term premium between the two is relevant. This is the equivalent of running a carry trade if the back end is sold at a higher level than the front end.
• To assess whether this carry trade is worth it, it needs to be risk-adjusted by volatility as in the graph below. With rising volatility, only GBPUSD volatility seems of some interest. Comparing across asset classes offers more insight. For example, we find the US term structure 1Y vs 3M has a slightly better risk reward.
• As the market trades various form of carry trades, it tends to flatten term premium in one asset class before moving to the next. Conversely, as this is likely traded as a portfolio of carry strategies, a back-up in one asset class propagates to others. In addition, there is likely an emphasis on carry trade with shallow tail profile which seems to be the case in longer dated G10 FX volatility.”

“The strange case of cheap corporate funding

• Corporates typically sell longer-dated EURUSD volatility as part of their hedging program and roll the position over, typically in industries with high profit margins and predictable cash flows. As many corporates do the same, it becomes self-fulfilling, keeping this part of the term structure at a very low volatility and hence high risk-adjusted returns. As a consequence, option desks likely sell longer-dated vols or take proxy positions in other currencies to do the same. The net result is a shallow slope above one year.
• The shallow slope for such volatilities suggest they benefit from a subsidized funding rate as by put/ call parity, it corresponds to a shallow funding slope, whereas the slope is upward sloping due to higher market and, more importantly, credit risk This seems a peculiarity of the currency market that proves persistent though might one day correct.”