Political crisis in Europe brings volatility back to forex options

Volatility returned to eurodollar last week, as forex traders priced further downside risk into euro options

Kevin Rodgers, Deutsche Bank

Foreign exchange traders began pricing further downside risk into euro options last week, as political events in Greece and Italy took their toll on financial markets. Following the resignation of Greek and Italian prime ministers George Papandreou and Silvio Berlusconi within a single week, eurodollar fell from 1.3785 on November 7 to 1.3581 on November 11, according to Thomson Reuters.

Although that fall was less dramatic than some had feared, volatility made a comeback last week, having seemingly abated in late October. One-month implied volatility on euro/dollar fell to 13.5779 on October 27, following the package of measures agreed at the Euro Summit in Brussels, but jumped back to 16.4266 on November 9, according to data from Deutsche Bank.

"The markets are extremely tired of all the volatility, and an element of exhaustion is creeping in among banks and funds. We are now entering a typically quiet and illiquid period, but the eurozone's large and complex problems are not being resolved to the market's satisfaction. The markets believe the chaos could continue for quite some time," says Kevin Rodgers, global head of foreign exchange spot, electronic trading and derivatives at Deutsche Bank in London.

"The euro has held up remarkably well, given the continued uncertainty, negative news from Greece and Italy, and the lack of resolution on the eurozone debt crisis. But the risk reversal, which was already heavily skewed for puts over calls, jumped from 3.7% to 4.1% last week, so euro puts are now more expensive to buy. The markets are disappointed, confused and looking for clarity. They hate nothing more than muddy waters – once we get clarity we can move on," says Stuart Scott, head of forex trading for Europe at HSBC in London.

Investors that bet on a euro fall via the options market have been wrongfooted by the strength in eurodollar, according to one forex trader at a European bank. "Everyone is still buying euro put spreads; people have tried to be short euro/dollar through options but it simply hasn't worked out, because the spot rate hasn't got lower," he says.

However, despite the volatility, some strategists remain bullish on the euro in the longer term. Société Générale Corporate and Investment Banking (SG CIB) predicts euro/dollar will weaken to 1.33 by the end of 2011 but will ultimately strengthen to 1.50 by the end of 2013.

"I have an underlying sense the euro is either gone or strong. If it does survive, it will be a strong currency relative to a very weak dollar," says Kit Juckes, head of forex strategy at SG CIB in London.

 

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