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In this write up we emphasize on the buying FX vols against equity vol, if within the mandate:
The EURUSD exchange rate was moving in a tight trading range yesterday. However, this was less due to the fact that there was a lack of momentum but the fact that USD strength and EUR strength were roughly evenly balanced. EUR benefitted from strong sentiment indicators as well as speculation that the ECB would surprise on the hawkish side after all tomorrow. So far the view had been dominating that the central bank would take an extremely cautious approach when it comes to exiting from its expansionary monetary policy, as inflation is currently still below target and as it wants to avoid stronger euro appreciation.
We, therefore, see a high likelihood that the scales will tip in favor of USD today as the appetite for EUR longs is likely to be limited immediately before the ECB meeting.
With equity volatility increasingly suppressed in 2017, we have in our recent notes focused on buying FX vol vs. equity vol as a theme (long EURGBP vol, short FTSE100 vol). In the latest outlook, we emphasized that with economic and technical forces suppressing volatility across asset classes (most in equities) FX is playing its role as the ‘adjustment factor’ for all economic changes and hence remains more reactive on a realized basis. This has been working in the Brexit-affected UK and elsewhere.
For more information on the sizing of cross-asset vol trades: Finding the best opportunities in variance swaps.
Risks to our recommendations: Prepare for vol bucketing: The main risk would be if the Italian election were held outside the February and March expiries, which would lead to the unfavorable distribution of volatility on these buckets.
However, we expect the overall downside to be limited given the close correlation between VStoxx futures.
Thus, buying FX vols against equity vols is advocated, if within the mandate: The risk would be if equity vol surging more than FX vol. investors going long (short) a volatility swap receive the realized volatility above (below) the traded level. However, they must pay the difference between the traded level and realized vol if the latter is lower (higher) than the former at expiry. The structure exposes investors to a sharp rise in the equity index volatility, with the 6m FTSE realized volatility ending 1.7x above the 6m EURGBP realized volatility.
