Newspaper headlines and investor feedback continue to suggest that the euro debt crisis is the leading risk to the global economy and financial markets.But the currency markets don’t seem to reflect this sentiment.
“You can’t walk into a bar without hitting a discussion of euro zone tail risk – and this includes bars in very out of the way places,” writes Steven Englander, Citi’s currency guru. “Yet the amount of tail risk that is actually priced in is astonishingly small.”
Englander points to the currency options markets. Simply put, Englander notes put options betting on a 15 per cent or greater decline in the euro in six months look surprisingly cheap. In fact, similar options on other arguably more stable currencies look much more expensive.
For you currency geeks, here’s the wonky version of Englander’s note:
The current premium for a view that the euro will be 15% cheaper in six months is about 7.4% (we use Bloomberg mid-pricing so these should be viewed as approximate). But the price for a bet that the euro will be 15% more expensive in six months is 4% so beyond the normal volatility there is maybe a 3% excess probability priced in for a really big euro move. By comparison the premium on USDCAD moving up by 15% or more over six months is 8%, and the cost of an AUDUSD 1.14 6m digital is 4%. Pricing for a similar USDJPY upside digital is 6.3%.
“My suspicion is that investor rhetoric is more dire than their willingness to buy insurance,” writes Englander.
But here’s the key caveat in Englander’s note: “Investors may be distinguishing between scenarios in which there is sovereign stress, which is very likely, and EUR stress, which they think is less likely if Greece stays in or is managed out gracefully.”
In other words, the relative calm in the currency options markets may belie what’s going on in the sovereign debt crisis.
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