(Thanks for the article, Harry)
Biggest Money in Currencies Is Made Selling Options (Update1)
2009-04-20 02:23:26.609 GMT
(Updates prices in 14th and 24th paragraphs.)
By Ye Xie and Liz Capo McCormick
April 20 (Bloomberg) -- This year's most profitable
foreign-exchange trade is signaling increased optimism that the
first global recession since World War II is easing.
Bets that currency swings will continue falling from record
highs produced profits in each of the past five months for a 32
percent gain, the best performance for that length of time,
according to ABN Amro indexes. The strategy was the only one of
four currency tactics simulated by ABN that made money in the
first quarter.
Currency fluctuations ebbed as global economies recovered
from the turmoil that followed Russia's 1998 default and the
Sept. 11, 2001, terrorist strikes. Now, the JPMorgan Chase & Co.
benchmark index of investor expectations for currency swings,
known as implied volatility, has fallen to 14.4 percent from its
27 percent October record. The G7 Volatility Index's decline
since mid-January is the steepest three-month drop since its
1992 inception.
"Big currency moves are behind us," said Maxime Tessier,
chief of foreign exchange at Montreal-based Caisse de Depot et
Placement du Quebec, Canada's biggest pension fund manager, with
C$120 billion ($98.6 billion) in assets. "The volatility spike
has to unwind itself over time. Selling volatility has been the
winning trade so far this year and will continue to work well."
Past Experience
That may be good news for the global economy. Within a week
of the 9/11 attacks, the JPMorgan index jumped to 13 percent
from 11 percent. By April 2002, that gauge of expectations for
U.S. dollar swings over the coming three months versus the yen,
euro, pound, Swiss franc, Australian dollar and Canadian dollar
had fallen to 8 percent as the U.S. recovered from a recession.
After Russia defaulted on $40 billion of debt in August
1998 during the Asian financial crisis, the index surged to
almost 19 percent in October, from 10 percent in May. It had
fallen by half when the global economy emerged from the meltdown
the next summer.
Today, investors are becoming more convinced that
unprecedented sums pledged by the world's major economies,
including $12.8 trillion from the U.S., will stem the worst
financial crisis since the Great Depression. The U.S. economy
will grow 0.3 percent in the third quarter, from a year earlier,
according to the median forecast in a Bloomberg survey of 59
analysts. It probably contracted 5 percent in the first quarter
and will shrink 2 percent in the second, the survey shows.
'Good Description'
"FX vol tends to be correlated with the business cycle,
and normally peaks after troughs in growth," Goldman Sachs
Group Inc. strategists led by London-based Thomas Stolper wrote
to clients on April 8. "That appears to be a good description
of the current situation."
JPMorgan's index remains elevated relative to historic
levels, signaling continued demand for protection. The index,
which usually moves in tandem with actual fluctuations, remains
above 14 percent, a level it has breached only seven times at
closing since its mid-1992 creation.
Expectations for swings in the U.S. dollar versus the
Canadian dollar over the next two years are about 15 percent,
compared with 14 percent for the next two months, suggesting
investors see currency volatility remaining elevated, Bloomberg
data show.
"Although volatility levels have peaked, they are still
pricing in significant market uncertainty in the years ahead,"
said Geoffrey Yu, a London-based foreign-exchange strategist at
UBS AG, the world's second-biggest currency trader. "So long as
the banking system is still under stress, people will want
protection. We are far from giving banks a clean bill of health,
which means there will be more nasty shocks along the way."
$4 Trillion in Losses
Since the start of 2007, the world's largest financial
companies have reported loan-related writedowns and losses of
$1.3 trillion, about the size of Russia's economy. Global losses
may total $4 trillion, the International Monetary Fund will
announce on April 20, according to an April 8 report in the
Financial Times.
RBS Securities Inc. takes a different view. In an April 15
note to clients, it said exchange rates for the euro, yen and
the dollar suggest there is little room for extreme swings
because they are closer to their 10-year averages than any time
since 1997.
Volatility expectations on three-month euro-dollar options
fell to 14.09 percent today from 25.39 percent in December, the
highest level since Bloomberg started compiling that data in
1998. Tessier predicted it will decline to about 11 percent.
'Doing the Opposite'
"People are still willing to pay a premium for insurance
against disaster, which is keeping implied volatility from
falling too much," said London-based Henrik Pedersen, chief
investment officer at Pareto Investment Management Ltd. "That
is probably why there is value in doing the opposite" by
selling options, said Pedersen, whose firm oversees more than
$46 billion. Traders use implied volatility to set options
prices.
Goldman Sachs' April 8 analysis concluded that actual
volatility on one-year euro-dollar options, which stood at 15.7
percent on April 14, is higher than the bank's economic model
suggests it should be by 4.7 points. The deviation was the most
since the mid-1970s, Goldman Sachs said.
Lower volatility typically follows the easing of monetary
policy by 18 to 24 months, said Alan Ruskin, head of
international currency strategy in North America at RBS in
Greenwich, Connecticut, in an April 15 research note. The
Federal Reserve lowered interest rates to a range of zero to
0.25 percent from 5.25 percent 19 months ago, in September 2007,
in an attempt to stave off the recession as the housing market
collapsed.
'Reassuring Investors'
"I would expect volatility to continue to drop," said
Andrew Milligan, the global strategy chief at Standard Life
Investments, which oversees $181 billion in Edinburgh. "We are
still expecting to see a lot of policy statements reassuring
investors that the governments are in charge, and we will see an
upturn in economic activities."
A so-called short volatility strategy, where investors sell
options that protect buyers against currency swings, gained 32
percent from Nov. 1 through March 31, ABN's Volatility Capture
Style Index shows. That's its best five-month performance since
the index's 1974 start and among the top dozen gains for that
length of time in any of ABN's four currency-trade gauges. The
volatility strategy had lost a record 29 percent in October. Its
12.8 percent drop last year followed smaller drops from 2005 to
2007 -- its first multiyear losing streak.
Straddles, Strangles
Investors typically short volatility by simultaneously
selling the right to buy and to sell a currency at set strike
prices, known as call and put options. When volatility
expectations fall, so does the price of that protection, and the
seller makes money. Such strategies can use identical strike
prices, known as straddles, or different ones, strangles, with
the former being riskier.
An investor who on Jan. 2 sold $10 million worth of three-
month euro-dollar option strangles with a call price of $1.5135
and a put price of $1.2921 would have reaped a $338,000 profit
at the end of the first quarter as implied volatility fell to
about 18 percent from about 23 percent, Bloomberg data show.
Momtchil Pojarliev, currency chief at Hermes Pension
Management Ltd. in London, said he has been selling volatility
since October, mainly with short strangles, which he considers
"definitely the winning bet." One of his positions is on the
Canadian dollar versus the U.S. currency. Pajarliev, whose
company oversees about $39 billion, predicted one-year implied
volatility on the pair will drop 3 points to about 12 percent.
Carry Trade
Smaller fluctuations benefit another common currency
strategy, the carry trade, where funds borrowed from countries
with lower interest costs are invested in those with higher
rates, allowing investors to pocket the difference. Low
volatility decreases the chance that sudden moves will wipe out
carry trade profits.
An increase in carry trades would boost currencies from
higher-interest rate nations, such as the Australian dollar, and
hurt legal tender from economies with lower rates, including the
yen. Over the past two months, the dollar in Australia, where
the central bank benchmark rate is 3 percent, has gained 18
percent to 70.86 yen in Japan, where the corresponding rate is
0.1 percent.
The Aussie lost 35 percent against the yen last year, when
three-month volatility expectations on the pair more than
tripled to a record 54 percent between January and October. It
is now 27 percent.
In Vogue
Selling option volatility was in vogue after the 2001
recession ended until mid-2007. During that period, increased
transparency by central banks and stable interest rates damped
currency swings. The ABN volatility-strategy index's best year
was 2004, when it gained 26 percent.
JPMorgan's volatility index for emerging markets rose to a
record 35.8 percent in October, from about 10 percent in August,
as currencies from Brazil's real to Iceland's krona weakened.
The volatility and currency depreciation caused Taesan LCD
Co., which makes computer screen lights in Pyeongtaek, South
Korea, to collapse in September as its currency derivative bets
went awry. Gruma SAB, Mexico's largest maker of corn flour for
tortillas, reported a 11.1 billion peso ($844 million) loss in
the fourth-quarter, in part from bad currency wagers.
"People got burned badly last year," said Pojarliev of
Hermes Pension Management. Now, "fear is disappearing. We are
moving towards a normal environment," he said. "We could see
more normal levels in volatility."
For Related News and Information:
Options and Volatility XOPT <GO>
FX Implied Volatility Matrix WVOL <GO>
Volatility Comparison: VOLC <GO>
Currency trade idea tools: FXTI <GO>
Positions and Sentiment: IPSP <GO>
Currency forecasts: FXFC <GO>
Developed-market monitors: DMMV <GO>
Emerging-market monitors: EMMV <GO>
--Editors: Phil Kuntz, Nicholas Reynolds
To contact the reporters on this story:
Ye Xie in New York at +1-212-617-2768 or
yxie6@bloomberg.net;
Liz Capo McCormick in New York at +1-212-617-7416 or
Emccormick7@bloomberg.net.
To contact the editor responsible for this story:
Dave Liedtka at +1-212-617-8988 or
dliedtka@bloomberg.net.
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