EUR/JPY risk reversals too high – SocGen
Olivier Korber, Research Analyst at Societe Generale, notes that the EUR/JPY 6m risk reversal (RR) is trading at -2.8, which supposes that the implied volatility should be strongly negatively correlated with the FX rate.
Key Quotes
“While the EUR/JPY RR has strongly mean reverted towards the vol/spot correlation since since 2013, this correlation has been about zero for a few weeks, due to yen disordered moves. So the EUR/JPY 6m skew is now disconnected from its fair value. We recommend two trades taking advantage of this mispricing.”
“Expression: Volatility and directional implementations
#1 Volatility trade. The natural trade to express our smile view is selling the RR, but the odds are even better in going short a EUR/JPY variance swap. The variance swap captures the skew on top of volatility, and the 6m implied volatility is trading significantly above both 6m and short-term realised volatilities. Since 2007, EUR/JPY 6m realised vol has been 78% of the time below the variance swap bid (versus only 58% for the ATM volatility).
#2 Directional trade. We keep our EUR/JPY bullish bias as a reflation trade set to benefit from further short covering. Buying a topside seagull is short both the excessive volatility and skew, and can be structured at zero cost.”
“Mechanics: Go short variance swap / Buy topside Seagull
#1 Go short EUR/JPY 6m variance swap @14.3 (EUR indicative bid)
#2 Buy EUR/JPY 6m topside seagull strikes 114/124/128 @ Zero cost (indicative, 122.80)”
“Risks: Higher realised volatility / EUR/JPY below 114
#1 6m realised volatility above 14.3 in 6m. Investors receive or pay the difference between the 14.3 strike (squared) and the terminal realised variance and face unlimited losses if realised volatility is beyond this strike level.
#2 Unlimited below 114. The structure is buying a standard call spread strikes 124/118 fully financed by selling a put strike 114. As such, investors face unlimited downside risk at the expiry if EUR/JPY trades below 114.”