One-month EURCHF implied volatility fell more the 16 vols from the close of trading on Friday to 8%, while one-week vols were being quoted at one stage yesterday as wide as 10/18, have settled at 8%, having fallen from an outright vol level of 26% from Friday’s close. Meantime one-year volatility fell almost 7.5 vols to 10.5%. Risk reversals for puts, eased 3.25 vols to 0.5%, according to traders.
| EURCHF implied volatility |
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| Source: Bloomberg |
Given this sharp one-off adjustment, the question now becomes, where does implied volatility find a floor and what shape does the new volatility curve take?
While the implementation of a peg at 1.20 immediately limits the risk to EURCHF downside, implied volatility isn’t likely to fall much below 10, says Arindam Sandilya, an FX strategist at JPMorgan in New York. Those levels would be in line with the average implied volatility over the past two years – with the exception of this summer’s levels. However the option market isn’t without risk.
Downside in volatilities is limited because yesterday’s measures do not represent a hard peg, thus the markets will want to question its long-term sustainability. Furthermore, the EURCHF will still remain susceptible to movements in other euro-cross currency pairs, while there is always a risk of topside moves, given the market is still likely to be positioned for CHF strength.
“As long as the SNB is resolute, there is no downside, there is only topside for EURCHF, and bounces in EURCHF on bouts of good news in Europe will emerge every once in the while. So a lot of people in the market are going to start playing EURCHF like they did in 2009,” says Ray Farris, global head of FX strategy at Credit Suisse. “They’re going to buy EURCHF topside calls RKOs and one touches.”
Option markets have now started to price a reshaping of the volatility curve, from what was an inverted curve at a high-base level of vol, to an upward sloping curve at a much lower nominal level of volatility. “The first order effect on the vol curve is that the vol surface dumps in parallel fashion, as the market is more sanguine at 1.20” says Sandilya. “It can be defended in the short term; however there’s uncertainty as to whether or not that policy can be followed indefinitely.”
Traders also warn against being short convexity, that is, vol of vol. For example three-month implied volatility fell 10 vol yesterday. As an example, on a double no touch structure with a three-month tenor and a range 1.18–1.24, option models were calculating a theoretical value of 1%, based on a vol price of 9%–10%. Yesterday, that structure traded at 26%, which indicates how central bank intervention can distort option pricing.
“It’s not about modelling any more, it’s about risk-return ratio and common sense,” says one global head of options trading. Other traders say that convexity risk will fade though, given that implied volatility is unlikely to move as much now that the currency floor is in place.
Pricing the option smile curve will probably be a complex task as well, argues Farris. That’s because confidence in how the floor breaks in the future will rise with time. For instance, the Swiss economy may adjust quicker than anyone expects and inflation could begin to rise. Regardless of the fact that the euro area is still a mess, EURCHF would have to go lower because the SNB has to start raising rates, argues Farris.
“You’re going get low vols at the front of the curve but rising through longer dates so that the curve is steep. Skew should increasingly become bid for calls in EURCHF, he says. "The smile for longer dates should become steep on both sides."