volga
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Given that this is something I dont think has ever been discussed in the forum..
this question/discussion is for the FX exotics specialists in the forum. In the brokered exotics market for SHORT DATED 1st Gen FX exotics (Reverse KO/Reverse KI/Double No Touch/One Touch etc) most firms use a model SLV model. keeping the approach straight and simple this is a model which is between local vol and stochastic vol and is generally steered by the trader using some sort of weights / mixing parameters based on how he thinks the market is behaving which allows him/her to calibrate the prices and trade around..
questions/topics for discussion:
a) which currencies behave in a more stochastic fashion and which behave more local. from a first guess I would think EURUSD to be more stochastic (random rr shifts between negative to positive very often) and USDJPY more local (rr is always usdputjpy call over). Would someone be able to be throw some light on this a little more from an intuitive angle
b) given that banks are generally structurally long OTs (they are all mostly selling reverse KO and buying reverse KI (rkomore cheap than vanilla and thus inverse for rki)) from clients..and thus long the embedded One Touch.. is there any relative value around this ? and in the fx exotics space how are traders jobbing this RV around.
c) theres a whole bunch of lingo/terms which the FX market uses like rega/sega/smile gamma/smile vega/risk reversal gamma etc ..would one of the fx exo experts in the forum mind clarifying these concepts with some simple 1st gen examples and their risk behaviour
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jungle
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| Chief Rhythm OfficerCSD LLC |
| Total Posts: 2921 |
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I'll leave b) and c) to people more involved in the space.
a) My intuition is that risk reversals are bid for calls on funding currencies analagous to equity indices and puts. This makes sense (at least to me) as carry and momentum strategies are the most popular in FX. Pairs like EURUSD aren't really carry currencies so there's less of a bias to the market's positioning and demand for riskies.
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"You can find me at the place where the rhythm comes from." Blaze, 'Afro-groove' |
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volga
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Thanks for your answer to a) Jungle. appreciated. This makes sense as for example someone doing the carry trade in usdjpy (not anymore) would like to protect his usd value by buying usd puts jpy calls etc. If I may politely add , my question was more hinting towards behaviour in vols from a local or stochastic angle..for example USDCAD riskies are calls over and USDJPY is Puts over and EURUSD keeps flipping between the two.I would think structural posiitoning of players do play an important role too but from a day to day movement is there anything else deeper apart from the reasoning you mentioned that is driving this type of a dynamic ? |
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volga
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| Total Posts: 91 |
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Thanks for your answer to a) Jungle. appreciated. This makes sense as for example someone doing the carry trade in usdjpy (not anymore) would like to protect his usd value by buying usd puts jpy calls etc. If I may politely add , my question was more hinting towards behaviour in vols from a local or stochastic angle..for example USDCAD riskies are calls over and USDJPY is Puts over and EURUSD keeps flipping between the two.I would think structural posiitoning of players do play an important role too but from a day to day movement is there anything else deeper apart from the reasoning you mentioned that is driving this type of a dynamic ? |
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RR is mostly, but not completely a result of how the FX rate has changed in the immediate past. RR change is correlated with spot rate change (i.e. when USDJPY goes up, USD calls get more expensive over JPY calls, measured by an increase in RR price for static delta structure).
This is easily confirmed by looking at historical RR and historical spot prices together, they move hand in hand.
Jungle's comment is not true, during the long USDJPY rallies USD calls have been very, very well bid. On the other hand, when carry trades go horribly wrong and e.g. USDJPY plummets, RR moves to very negative levels.
The RR phenomenon is often tied to carry trade pairs, as these pairs generally move in trends and therefore create persistent and large RR premiums, positive or negative.
There was a recent paper studying RR formation, but can't find it anywhere now. As a rule of thumb, I suggest betting against large absolute RR premiums, as it is mean reverting. |
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volga
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| Total Posts: 91 |
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Thanks MoreLiver. there was a paper lying around somewhere name "Information content of risk reversals" or something like that..put me to sleep..would you mind sharing some of your thoughts on questions b) and c) ? |
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Dimatrix
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Dimatrix
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In that paper they say that risk reversals are zero cost strategies. I don't see why that should be true. A long call with a delta of 0.25 and a short put with a -0.25 delta does not imply that the corresponding position has a zero value? The premium might be small but not zero, right? |
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FDAXHunter
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| Correct for the 25 Delta RR. But you could also have a different delta on the put side than on the call side such that the cost is zero? Maybe that's what they mean? |
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Dimatrix
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Probably yes. They write:
The strikes of risk reversals are chosen so that the cost of buying the put offsets the premium received for selling the call.
While this can certainly be done, this is not what is done when choosing the 25 Delta setup. |
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Graeme
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| Suppose you have decided on the one option strike. You can then decide on the other option strike according to 1. equal delta, or 2. equal premium. You almost surely can't do both at the same time, and if you understood that they were saying you could, it's probably bad semantics on their part. |
Graeme West |
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| This might be of interest: Carry Trades and Currency Crashes by Brunnermeier et al. Edit: google finds the pdf and ppt-files. |
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volga
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| guys I got an answer to b) today , I will write a detailed post on this later , but could someone from FX Options please help in clarifying these concepts (in the way they are looked at in FX space) |
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