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THOMSON REUTERS

2015 EDITION

THOMSON REUTERS OVERALL MARKET SHARE WINNER MULTI-DEALER PLATFORMS

In association with

REDEFINING CONDUCT IN THE FX INDUSTRY

THE CHANGING ECOLOGY OF THE FX MARKET

GROWTH CURRENCY: RENMINBI

featuring Guy Debelle, Reserve Bank of Australia

featuring Douglas Cifu, Virtu Financial

featuring Beng-Hong Lee, Deutsche Bank

VALUING FX VOLATILITY by Ron Leven, PhD, Thomson Reuters

FX EXCHANGE THOMSON REUTERS

2015

CONTENT

INTRODUCTION

ARTICLES 2 Redefining Conduct 5 Tectonic Shifts 10 Growth Currency 12 Looks Can Be Deceiving

FX in 2015: all change Over the 34 years in which Thomson Reuters has been active in foreign exchange, there has arguably never been a period of more significant change in the industry than we are witnessing in 2015.

CONTRIBUTIONS

Against the backdrop of conduct-related fines and the growing burden of capital, the sell side is now much more focused on profitability and risk management than on growing market share.

EDITORIAL

For the buy side, assets under management continue to grow, but risk is now being priced very differently, so firms find themselves facing the twin challenges of increased risk and less liquidity. As asset managers and corporates deal with that trading risk, they need to manage their orders much more actively than they did in the past.

Joel Clark Freelance Journalist

Victoria Hood Head of Marketing, FX and Fixed Income Thomson Reuters, Financial & Risk

In this second edition of FXExchange, we examine these induxtry challenges through the lens of a number of key themes, including market conduct and the changing ecology of the FX market. We also consider the increasingly important role of the Chinese renminbi, and offer some ideas and tools to track the effects of volatility on currency values.

Ron Leven, PhD Head of FX Pre-Trade Strategy Thomson Reuters, Financial & Risk

DESIGN AND DEVELOPMENT

I hope you find the insights useful, and look forward to continuing to work with our partners and clients in the coming year.

Thomson Reuters Global Creative Services

Phil Weisberg Global Head, FX, Thomson Reuters

© 2015 Thomson Reuters S020842/5-14

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REDEFINING CONDUCT

THOMSON REUTERS FX EXCHANGE

In the two years that have passed since damaging allegations were first made about improper behaviour among foreign exchange traders, the microstructure of the industry has been more closely and widely scrutinised than ever before. But while the market manipulation that has been unearthed has clearly damaged the industry’s reputation, significant progress has already been made to address key issues. “Most market participants still care very deeply about the integrity of the industry and have been working collectively to come up with constructive suggestions to address past failings. In the long term, dealing appropriately with these conduct issues will be to the industry’s benefit,” says Guy Debelle, assistant governor at the Reserve Bank of Australia and chair of the Australian Foreign Exchange Committee.

By Joel Clark

Investigations into benchmark manipulation have cast a long shadow over the FX industry, but efforts to address what went wrong through stronger behavioural standards are now well advanced.

Standard-setting bodies and industry leaders began addressing key policy objectives even before regulators had completed their investigations into manipulation of FX benchmarks. A working group of the Financial Stability Board (FSB), co-chaired by Debelle and the Bank of England’s Paul Fisher, was convened early last year and published its final report on FX benchmarks in September, containing a number of important recommendations, some of which have already been put into action. Meanwhile the Bank of England initiated its Fair and Effective Markets Review (FEMR) in June 2014, which consulted widely on how to restore trust and confidence in fixed income, currencies and commodities markets, issuing a consultation document in October, with the final framework expected soon. Both the FSB benchmark review and FEMR were well-advanced by the time the first batch of fines were meted out to banks in November 2014, with the UK Financial Conduct Authority (FCA) fining five banks £1.1 billion for “failing to control business practices in their G-10 spot FX trading operations”. Serious and damning as those fines may have been – they constituted the largest ever imposed by the FCA or its predecessor organisation – the remediation efforts highlight the widespread commitment to restoring the reputation of the industry.

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“The work is clearly not yet finished,” says Debelle. “Efforts are still ongoing, and everyone is taking it extremely seriously. The banks have spent a lot of time on this; they have tightened up their internal controls and have compliance officers on the trading floor monitoring trader behaviour and interaction with clients.” One of the most fundamental challenges for the industry, which underpins efforts by the FSB, the Bank of England and the banks themselves, has been to find a way to enforce better behaviour among traders without making major changes to the market structure that could have an adverse effect on liquidity and access. In the past, FX market committees and industry associations drafted codes of conduct to engender consistent and fair behaviour across institutions, but the investigations showed that those behavioural codes had in many cases not been properly enforced, allowing some traders to seize on opportunities to manipulate exchange rates. Beefing up those codes and aligning them to ensure international consistency is now a priority for the whole industry. On March 30, eight foreign exchange committees jointly published a high-level set of conduct principles that should be expected of all participants. The eight-page document, Global Preamble: Codes of Best Market Practice and Shared Global Principles, is not intended to replace codes of conduct or regulations already in place in different regions, but rather aims to harmonise behavioural standards internationally. “The challenge we have encountered is that one can write high-level guidelines that everyone agrees on, but the more specific it gets, the harder it becomes. It is impossible to define every scenario that is or is not permissible, so we want participants to use the globally agreed principles to help them reach their own conclusions about what kind of behaviour is appropriate,” says Debelle. Key principles covered in the preamble include personal conduct, confidentiality and execution practices. At an annual meeting of the eight FX committees held in Tokyo on March 23, officials unanimously endorsed the preamble and committed to further work to harmonise regional codes of conduct and to find ways to promote

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more consistent adherence. The commitment of the FX committees to global consistency has been welcomed by the industry. “There is clearly a very strong desire for coordinated alignment of the regional codes of conduct so that we reduce duplication and create a common reference point for the industry on a global basis. This is an opportunity for market participants to demonstrate that they can put the right controls and rules in While work continues on enhancing place going forward,” regional codes of conduct to improve says James Kemp, and standardise behaviour across managing director of the global FX industry, central bank the Global Financial governors now have their eye on a Markets Association’s single global code. global FX division, which represents 24 Following a meeting of the Bank banks in the FX market. for International Settlements’ (BIS) Economic Consultative Committee (ECC) on May 10-11, BIS governors set out the terms of a new working group, chaired by Guy Debelle. “The BIS Governors have agreed to set up a working group under the auspices of the Markets Committee to take these issues forward with a view to facilitating the establishment of a single global code of conduct, standards and principles,” said ECC chairman Agustín Carstens.

Among the most important issues requiring attention in the wake of the investigation, Kemp believes, are the need for clearer disclosure about the capacity in which a bank acts when it trades with a client, as well as clearer in-house guidelines on execution of client orders and internal and external information flow.

The global preamble addresses the disclosure issue from a high level by requiring that all firms must identify “potential or actual conflicts of interest that might arise when undertaking FX transactions, and take measures either to eliminate those conflicts or control them so as to ensure the fair treatment of counterparties”. Market participants acting in an agency capacity must not undertake trades that could result in a conflict of

TECTONIC SHIFTS

interest without disclosing it to the customer first and making sure any conflict is resolved, the preamble adds. “There is certainly a need for greater disclosure on the capacity in which participants act. As the same salesperson often represents different services within an institution, including both agency and principal, both the provider and the client need to be absolutely clear on the type of engagement and the conduct rules that apply,” says Phil Weisberg, global head of FX at Thomson Reuters. In addition to greater disclosure and control of information flow, a further priority is to ensure that market participants are compensated for the risks they take by participating in certain business practices such as benchmark fixings, Weisberg adds. The FSB report recommended that fixing transactions should be priced “in a manner that is transparent and consistent with the risk borne in accepting such transactions”. Accordingly, some banks are now charging clients for executing their orders at the 4pm London fix. “Creating a business that imposes trading risk but doesn’t have an explicit revenue model associated with it could create the potential for harmful behaviour, so it is important to make sure market participants are compensated for the risks associated with particular business models,” Weisberg explains. As industry officials work with central banks and regulators over the coming year to review the regional FX committee codes of conduct and ensure they are properly and consistently enforced, it will be critical to make sure such issues are properly addressed. The alternative to dealing properly with conduct issues now, Kemp believes, could be more fundamental and possibly detrimental changes to the market structure. “One key question has been whether the findings of the investigation and market reviews point to the need for changes to the structure of the market or to the need for enhanced conduct in the market,” says Kemp. “The general consensus is that the current FX market structure works well and provides a good service for end users. Given that sentiment, what is clear is that bad conduct absolutely needs to be dealt with through enhanced conduct guidance and enforcement, while any structural change should be kept to a minimum to ensure we retain an effective market for end users.”

By Joel Clark

The provision and consumption of liquidity in the FX market has evolved in recent years, with new participants and distribution mechanisms, but concerns have been raised about the market’s resilience at times of stress. Movements in the gigantic tectonic plates beneath the earth’s surface are slow and imperceptible to the human eye. But over the course of millions of years, it is those gradual shifts that form the world’s highest mountains and its deepest ocean trenches. Similarly in the foreign exchange market, subtle changes over the past seven years are contributing to a major transformation in the ecology of the industry. As regulation bears down on the banking sector and technology plays an ever more important role in the provision, distribution and consumption of liquidity, a new market structure is emerging.

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“It used to be that buy-side firms would hand their orders to banks and trust them to take it from there, but the industry has changed and the buy side is now taking much greater control. The challenge is that there are fewer banks with sufficient capital to respond to sudden currency moves, which can lead to patchy liquidity and air pockets at times of market stress,” says Phil Weisberg, global head of FX at Thomson Reuters.

“The institutional Swiss franc market was effectively closed for about an hour after the SNB announcement, which was to be expected, but liquidity in the forward market was disrupted for several business days. That suggests traditional liquidity providers may have had less ability to warehouse risk as a result of regulation, and were therefore less committed to the market during that period,” says James Wood-Collins, chief executive of Record Currency Management.

A reduction in liquidity is a serious concern for all participants in a market that has always been credited as being very liquid, allowing end users to transact as and when they need. But as the role of banks and alternative market makers in the provision of liquidity has changed, buy-side firms are finding that the FX market is not quite as reliable as it has been historically, particularly during times of stress.

To some extent this kind of scenario is inevitable in a world in which Basel III is forcing banks to hold a much greater quality and quantity of shock-absorbing capital, which incentivises less risk-taking across business lines. While FX trading consumes less capital than some asset classes, a sudden risk-on environment might make banks more likely to step back.

“As end users have demanded more choice and better prices, we now have many more ways of delivering our prices to them.”

In the event of a major move in a particular currency, some warn that market makers are now more risk averse and more likely to react in the same way, making sharp oneway moves much more common. That has created concerns that the market’s resilience to sudden moves may be declining.

“To make prices in currencies, market makers have to be willing to risk trading capital, and in volatile market conditions they would need much more capital to be available, – Douglas Cifu so liquidity tends to get Virtu Financial thinner at times of high volatility,” says Neill Penney, head of workflow management proposition at Thomson Reuters.

This became particularly apparent on January 15, when the Swiss National Bank (SNB) suddenly removed the currency floor it had maintained for more than three years on the EUR/CHF exchange rate. The surprise policy decision triggered chaotic market conditions as the value of the Swiss franc soared and participants scrambled to protect their positions and prevent losses. It also led to an unnerving shortage of liquidity at a time when participants needed it most.

The growing capital burden is one of a number of pressures banks are facing in the FX market today; they are also dealing with the impact of the benchmark investigation and subsequent market review. While not all banks were fined for market manipulation, most are now having to manage the changes that have been made to the fixing process, including the widening of the calculation window for the WM/Reuters 4pm fix from one minute to five minutes.

More fundamentally, the conflicts of interest that have been exposed by the investigations have led to greater scrutiny of business models, and a need for more robust internal controls and disclosure to clients. Getting that right requires banks to create a whole new layer of infrastructure that didn’t previously exist, raising barriers to entry that were already fairly high. “Large banks need to have processes and procedures in place to manage the inherent conflicts that exist when they are making prices to the buy side but are also a principal in the same business. That ramps up the fixed costs of operating as a market maker, and the investment now has to be made in internal processes rather than product innovation,” says Weisberg. Meanwhile the prospect of further regulation of some FX products, including mandatory clearing and trading on swap execution facilities, requires additional investment in infrastructure and connectivity to ensure client trades can be processed in compliance with the regulations. As banks deal with the sharp rise in operating costs that has played out in recent years, fierce competition for market share has been replaced by a simpler fight for profitability. Some believe concentration is inevitable, particularly among mid-tier banks that might not have a particular regional focus but previously aspired to compete in the top tier of the market. “It used to be the case that a big investment could allow any type of bank to build an electronic FX franchise, but it is now more than just technology that is needed. Natural liquidity flow and the connectivity and scale that come from it are also critical, but that is much harder for smaller entities to generate, so I believe we will see some concentration in the number of banks

2015

active in the market,” says Eddie Wen, global head of electronic trading for rates, FX, commodities and emerging markets at JP Morgan. In some ways, this might seem the ideal opportunity for non-bank market makers to step up to the plate. Free from the constraints of bank capital requirements and propelled by smart and fast technology, a host of non-banks have carved out a significant role in liquidity provision to the FX market in recent years. Also known as high-frequency traders, this relatively new breed of market participants have often been the subject of negative publicity, particularly in the equity market where they have been accused of front-running orders and rigging markets. But it is now generally accepted that alternative market makers have a positive contribution to make to FX market liquidity. “Alternative market makers are very good at tightening the top of book in liquid markets,” says Weisberg. “That has shifted the balance so that people who have small amounts to trade are served more consistently by alternative market makers at times of normal or low volatility. Those trading larger orders in stressed market conditions may still be better served by banks.” For alternative market makers, the most positive transformation of recent years has been the proliferation of distribution channels that enable them to make prices to liquidity consumers. The growth of disclosed trading venues as well as the willingness of banks to take prices from non-banks and redistribute them to their own clients on an agency basis has created an attractive business model for alternative market makers.

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One example is Virtu Financial, which successfully completed an initial public offering on NASDAQ in April and has significantly grown its presence in the FX market over the past year. The firm’s net trading income from global currencies grew from $20.7 million in the first quarter of 2014 to $42.2 million in the same period this year, according to its latest results. “Virtu and firms like us have always been very good at efficient price discovery and providing attractive liquidity, but what we lacked historically was the ability to distribute those prices to the buy side. As end users have demanded more choice and better prices, we now have many more ways of delivering our prices to them,” says Douglas Cifu, chief executive of Virtu. While high-frequency traders have often been accused of using super-fast technology to exploit inefficiencies between markets and platforms to gain a competitive edge, Cifu counters that it is actually the transparency and efficiency of the FX market that has allowed Virtu to succeed. Technology plays a central role, but the model requires efficient markets, he says. “Bid-offer spreads have significantly tightened in the FX market over the past five years and Virtu has been able to capitalise on that increased efficiency by delivering valid and robust liquidity to the market. We have reduced transaction costs in the financial ecosystem and made price discovery more efficient for end users, allowing them to move in and out of positions more easily,” says Cifu. But while alternative market makers may deliver efficiencies, the model doesn’t suit all buy-side firms. Record Currency Management, for example, runs bespoke currency programmes for clients and trades mainly in FX forwards and swaps. The firm’s choice of counterparty is based primarily on price and creditworthiness, with the latter being much easier to assess for a bank than a non-bank.


“Every bit of risk and reward we create for a client in a currency management programme sits on the counterparty’s balance sheet until maturity, so we have to think hard about who that counterparty is and what its credit rating is. Even if alternative market makers provided significant liquidity in forwards, we would need to be able to fully assess their creditworthiness for them to be on the other side of the trade from our clients,” says Wood-Collins. For market makers, the evolution of the industry in recent years has created a more level playing field as major trading platforms have introduced new rules and controls to slow down the technology arms race. Tools such as randomised order processing aim to grant equal opportunities to market makers, regardless of how fast their systems might be, while a host of other rule changes and surveillance mechanisms have been implemented to prevent market abuse. Against this backdrop, banks and non-banks are often considered to be vying against one another for market share, but the evolving market structure has blurred the lines between market participants, to the extent that the two groups often act as both clients and competitors to one another. “We view banks as business partners rather than competitors, because most of them now recognise that they can take our prices for whatever purpose they want, whether it is to redistribute to their clients at their own mark-up, or to use it to hedge their own exposure. We are just another source of liquidity that complements our bank partners,” says Cifu. “The traditional dealer to client relationship has changed,” adds Wen of JP Morgan. “Our clients provide us with liquidity that helps us trade better with our other clients. We also trade with alternative market makers so they, too, become a liquidity source for us. Our business model is to manage our positions and liquidity as best we can, regardless of the type of counterparty we are dealing with.”

PHANTOM LIQUIDITY: A BUY-SIDE VIEW Michael O’Brien, director of global trading at Eaton Vance, shares his perspective on the changing nature of liquidity in the FX market It is at moments of extreme market stress, such as the Swiss National Bank’s surprise policy decision in January, that weaknesses in the FX market structure are laid bare, but some buy-side firms have been finding it increasingly difficult to access liquidity in normal market conditions. “There is often a disconnect between the tight bid-offer spreads we see quoted on the screen and the actual prices we can transact at, particularly for large orders. The market operates at a much higher speed now, so by the time we have placed a trade with a bank, the price will often have moved,” says Michael O’Brien, director of global trading at Eaton Vance in Boston. Recognising that banks’ ability to provide liquidity is also being constrained by the growing burden of regulation, O’Brien believes market participants need to come together to find alternative models for sourcing liquidity, such as peer-to-peer matching between buy-side firms, or crossing with retail flow. “There is still very strong demand for foreign exchange from asset managers and corporates, so we need to establish where the supply is going to come from in the future, and I believe that’s a technology issue. The banks will always play a critical role in the FX market, but we may see more liquidity residing elsewhere,” O’Brien explains. Finding an alternative channel for liquidity consumption will take time, and until it happens O’Brien believes the FX market may be less resilient than it was during the financial crisis. “FX performed well in 2008, but I’m concerned that it may not be as robust if a similar crisis were to happen today, given liquidity is shallower,” he says. At Eaton Vance, electronic platforms and aggregators play a growing role in FX trading, but the firm is careful to choose execution channels that add true value to its business. “We don’t use single-bank platforms and we’re doing less algo execution than we did in the past as we have found those tools to be less effective. Our business has evolved from a world where we used the phone almost exclusively to one where we make much greater use of electronic platforms and alternative market makers, but we’re looking for unique models rather than just another RFQ platform,” says O’Brien. Although Eaton Vance generally does not use the 4pm London fix that lay at the centre of the market manipulation scandal, the firm has been closely observing recent structural changes, including the clampdown on conduct inside banks. “We have seen use of chat-room messages and even some phone conversations being restricted. In general, banks are being more conservative in the way they interact with the market,” says O’Brien.

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“Just as China’s rapid yet predictable growth has been a comforting constant at a time of unprecedented global economic upheaval, the ascent of its currency has been sure and swift – surer and swifter indeed than few thought possible and even fewer predicted,” observed HSBC group chairman Douglas Flint in a speech in London last year. Progress may have been swift, but renminbi’s share of global FX turnover is still small in relative terms. The currency makes up less than 0.7% of trading in London, according to the latest semi-annual survey by the Bank of England, and it ranked as 9th most actively traded currency in the 2013 survey by the Bank for International Settlements, trailing a long way behind the US dollar, euro and yen.

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Meanwhile China itself is expected to push ahead this year with the launch of its long-awaited international payment system, known as CIPS, which will enable standard cross-border clearing of renminbi among onshore and offshore participants. With a number of banks understood to be testing the system already, it is expected that CIPS will remove common processing challenges encountered when trading renminbi, placing it on a more level footing with other global currencies. “The introduction of CIPS will mean that instead of having an offshore clearing bank connected into the PBoC, clearing can finally be done through the domestic central banks, which is a format that is more familiar from the rest of the currencies that we deal with and much more efficient,” says Lee.

“The ascent of its renminbi has been surer and swifter than few thought possible and even fewer predicted.”

GROWTH CURRENCY By Joel Clark

Chinese renminbi is well on its way to becoming a major global currency, driven by the commitment of Chinese and international authorities to develop the necessary market infrastructure. There has never been any doubt that the continued growth of China’s influence on the world stage would eventually lead the country’s currency to become a growing force in the global FX market. But the liberalisation of renminbi over the past five years has happened at a pace that has surprised even the most hopeful of market participants.

Since currency controls first began to be relaxed in 2010, Chinese authorities have pursued an aggressive agenda to create a major offshore currency for trade, investment and reserve management purposes. Renminbi is now supported by central banks and commercial banks in a host of major financial centres, while international investment schemes have opened up the currency to global participation for the first time.

But it is widely expected that For investors, access to renminbi renminbi will eventually sit has been enabled by the continuing alongside the world’s top growth of the Renminbi Qualified currencies as investors, Foreign Institutional Investor (RQFII) corporates, commercial banks scheme. As the trading band and central banks build the between which renminbi is allowed infrastructure needed to support to trade against the US dollar has the currency. Renminbi is already been gradually widened in recent the fifth most active currency for – Douglas Flint years, RQFII has offered a global payments, according to HSBC group mechanism for renminbi SWIFT’s monthly RMB tracker, accumulated offshore to be invested back into China. and its use as an investment currency is also growing. “The use of renminbi as a trade financing and payments currency has grown very rapidly, to the extent that corporates can now buy and own the currency, as well as using it to pay for goods and services. As a trade currency, we can consider it to be liberalised already, and it is making good progress in becoming a major investment and reserve currency in its own right,” says Beng-Hong Lee, head of markets China at Deutsche Bank in Shanghai. One of the most significant developments, Lee believes, has been the proliferation of offshore clearing centres, a process that requires the People’s Bank of China (PBoC) to officially designate a clearing bank for that centre. While renminbi can still be traded in locations that don’t have their own clearing bank, the existence of a clearing bank drives greater awareness and understanding of the currency.

Use of renminbi among central banks is less widespread than among commercial banks, investors and corporates, but some reserve managers are already understood to be including the currency in their reserve allocation. Just as the increase in offshore clearing centres and expansion of RQFII have generated opportunities for investors and corporates, the admission of renminbi to the IMF’s special drawing rights (SDR) basket, which currently includes the euro, yen, sterling and US dollar, could have a similar effect on reserve managers. “We will continue to see a lot more investment channels open up into and out of China, as QFII and RQFII are expanded to more locations and their quotas are increased. Use of RMB as a reserve currency will also continue to rise, particularly if it is accepted as part of the special drawing rights regime,” says Lee.

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LOOKS CAN BE DECEIVING

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LOOKS CAN BE DECEIVING Ron Leven, PhD, Head of FX Pre-Trade Strategy, offers thoughts on the trends in vols and their effects Exchange rate volatility has trended higher in 2015 as expectations of a Fed rate hike and the Greek debt situation have both evolved. Implied vols for most currencies are above 2014 closes; but the JPY is an exception as volatility has drifted lower. USD/JPY 3-month implied volatility is now at levels traded in the fourth quarter of last year. As shown in figure 2, the contra-trend down-drift of USD/JPY implied volatilities makes them the lowest for any G10 currency vs the USD. The combination of JPY vols trading near the lows of the year (and well below other G10 vols) might make it appear to a corporate treasurer that JPY options are an attractive way to hedge exposure. But sometimes prices are low for a reason, and this seems to be the case for the JPY. The red bar in figure 1 below shows 3-month implied volatility relative to 3-month realized volatility. While JPY implied volatility is low relative to other G10 volatilities, it is quite high relative to where volatility is realizing. The case for JPY implied volatility being expensive is perhaps even more evident in figure 2. While implied volatility is near the year lows, a wide gap has opened between implied and realized. This divergence suggests there is probably a bias for JPY implied volatility to sink FIGURE 1: 3-MONTH VOLATILITY

So how then does a corporate treasurer, or any other FX market participant, evaluate vol value opportunities? SCANNING FOR VOLATILITY VALUE Thomson Reuters introduced the Currency Value Tracker into Eikon in April 2015 to allow users to quickly screen a variety of metrics to get a broader picture of dearness and cheapness. The tracker allows the user to build a custom array of volatility and carry oriented metrics and set tolerance filters to isolate market extremes. In the example in figure 3, the tracker is filtering implied volatility outright and relative to realized vol with blue and red indicating market extremes of lows and highs, respectively. This framework makes it apparent that it is ambiguous whether JPY volatility is cheap relative to other currencies. NOK volatilities are in the opposite situation of being high outright but low relative to realized. EUR/GBP volatility stands out as being relatively low on both metrics, making it the best candidate for using options as a vehicle for hedging exposure. TAKING THE ‘RISK’ OUT OF RISK-REVERSALS Risk-reversals are another factor that users can filter in the Currency Value Tracker. This is particularly

FIGURE 2: 3-MONTH USD/JPY VOLATILITY

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A scan of the table in figure 4 indicates that JPY volatilities are not strongly skewed outright or on a vol-adjusted basis. AUD skew is more extreme (bright blue) outright but only modestly extreme when adjusted for the level of implied volatility. EUR skew is also the most extreme (bright blue) outright and is also extreme adjusted for implied volatility, suggesting that users that need to hedge a short EUR/USD position (so the risk reversal would be short the more expensive put and long the relatively inexpensive call) should consider using risk reversals instead of forwards. SCANNING FOR VALUE IN CARRY Hedgers also need to be able to make assessments of the cost of carry. In addition to reporting current outright annualized net carry, the tracker also allows the user to filter carry relative to realized and implied volatility. The Currency Value Tracker also includes ’static‘ carry, which is a ratio of the net carry return vs the cost of buying at-the-money forward vs at-the money-swap call spread. This ratio specifically shows the potential return of capturing carry via options. Static carry is somewhat useful for hedgers as it can

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help identify currencies where low delta options are better value vs at-the-money options but it is particularly useful for investors looking for opportunities to earn carry. A high ratio indicates option volatility is underpriced relative to carry. The tracker can produce the chart in figure 5 with outright net carry and vol-adjusted carry on the axes and the bubble size indicating static carry. Currencies in the upper right are relatively expensive to short while currencies in the lower left are expensive to be long. EUR/NZD particularly stands out as having the highest carry while also offering relatively high static carry. Eikon users can access the Currency Value Tracker in the App library or by typing ‘FX Ranker’ in the navigation bar. For those wanting more information on this product, please send inquiries to [email protected]. FIGURE 5: G10 CARRY OUTLIERS

FIGURE 3: FX VOLATILITY VALUE TRACKING Currency

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3M Implied Vol/ Realized Vol

3M Implied Vol

USDJPY

7.400

1.321

USDNOK

12.700

0.794

EURGRP

8.040

0.787

FIGURE 4: FX RISK REVERSAL VALUE TRACKING

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still lower so options may not be good value after all.

important for hedgers as it highlights situations when risk-reversals offer particularly skewed reward vs risk compared to using a forward. Since skew tends to widen as volatility moves higher, it is important to assess extremes relative to implied volatility as well as on an outright basis.

2015

JPY

GBP

CAD

EUR

CHF

AUD

SEK

NOK

Y AXIS: % RED: IMPLIED VS. REALIZED VOLATILITY (FACTORED BY 10) BLUE: IMPLIED VOLATILITY

NZD

Currency

3M Risk Reversal Skew

3M Risk Reversal Skew/ Implied Vol (%)

USDJPY

0.850

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AUDUSD

-1.625

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EURUSD

-2.063

-18 Source for all graph data: Thomson Reuters Eikon

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