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I This has been prepared solely for informational purposes.

It is not an offer, recommendation or solicitation to buy or sell, nor is it an official
confirmation of terms. It is based on information generally available to the public from sources believed to be reliable. No representation is
made that it is accurate or complete or that any returns indicated will be achieved. Changes to assumptions may have a material impact on
any returns detailed. Past performance is not indicative of future returns. Price and availability are subject to change without notice.
Additional information is available upon request.

DB Guide to Risk Reversals
19
th
October 2006

Inside:

Skew Analysis

Risk reversal
valuation
methodology

G-10 risk reversals

Analysis of model

Valuation Summary
Table


Apurv Jain

Mark Stafford

212-250-8060
How to value risk reversal contracts and identify
relative value trading opportunities
• We link skewness of the FX spot return distribution to the
risk reversal contract and propose a methodology to value
risk reversals with respect to implied and realized
volatility to find relative value trading opportunities
• In most cases realized skewness of the distribution is less
on an absolute value basis than the implied skew

• We observe that a sharp movement in spot is usually
followed by a risk reversal “overvaluation” as “risk
premium” increases and implied skew in the following
periods is higher than realized skewness of the
distribution. Additionally, the back end risk reversals tend
to exhibit more overvaluation

• We also discuss applications of conditional variance
swaps as a means of taking advantage of the “risk
premium”
O
N
1
m
3
m
1
y
10p
DN
10c
6
7
8
9
Implied vol
Time
Strike
Skew

F
X


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G
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M
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Deutsche Bank


• We link skewness of the FX spot return
distribution to the risk reversal contract and
propose a methodology to value risk reversal with
respect to implied and realized volatility to find
relative value trading opportunities
• In most cases realized skew is less on an absolute
value basis than the implied skew
• We also observe that a sharp movement in spot is
usually followed by a risk reversal “overvaluation”
as “risk premium” increases and implied skew in
the following periods is higher than realized skew.
Additionally, the back end risk reversals tend to
exhibit more overvaluation
• We also discuss applications of conditional
variance swaps as a means of taking advantage of
the “risk premium”
Introduction
The famous Black Scholes model for option pricing
has a questionable assumption of constant volatility
of the return distribution, which doesn’t hold up to
empirical examination. In fact there is well
documented correlation between spot levels and
the implied volatility levels. This correlation which
results in the well known smile or a smirk effect in
options on various asset classes is also included in
the new and more complex models of option
pricing. Risk reversals are liquid instruments that
allow exposure to this correlation between volatility
and spot levels.

In this article, we propose a simple methodology to
value risk reversals and propose trade ideas based
on those valuations. We take USDJPY as an
example to walk through the analysis.

Skew- an intuitive explanation
Skew means that the return distribution will be
asymmetric and the left or the right tail is “heavier.”
The absence of skew means that a distribution, for
example the normal distribution, will be symmetric
with both tails having the same weight. As an
illustration of the concept, notice in fig. 1, the lighter
distribution has a left tail that is heavier than the
darker colored normal distribution. The lighter
distribution is referred to as a negatively skewed
distribution.

In options markets, a thicker left tail of the return
distribution means that OTM put options have a
higher probability of finishing in the money as
compared to an OTM call with the same delta. The
delta of an option, which is an approximation of the
probability of the option finishing in the money, is
computed under Black Scholes by assuming that
the return distribution is normal. This phenomenon
of skew has been observed in other markets as well
- wherever there is correlation between implied
volatility and spot we will see a skew. In the case of
equity indices, falls in equity prices are accompanied
by sharp increases in volatility. Even if the spot rate
is kept constant, an increase in volatility makes an
option more expensive since the price of a
European or American style option always increases
as volatility increases. So naturally, if volatility
increases as the spot level falls, the value of the put
option increases even more than would be
expected with a mere decrease in spot levels. The
mechanism described above gives rise to the
“skew” in the implied distribution. The implied
distribution is what the market expects and the
realized distribution is what really happened.
To the extent that implied and realized distributions
diverge systematically and consistently, we conclude
there is a “risk premium”. The presence of a risk
premium is usually accompanied by a trading
opportunity. Now imagine the case where on average
the “expected” (risk neutral) correlation between
implied volatility and spot levels implied by the
distribution is on average similar to the correlation
observed in reality, over time we would say there is
no “risk premium.” However, if we see that the
market consistently prices in a different correlation
Fig 1. The light distribution has a negative skew
and the dark one is normally distributed


Fig 2. Out of money puts and deep in the money
calls in equities are more expensive
S&P 500 Dec 2006 Option Strike vs. Implied Vol
10
10.5
11
11.5
12
12.5
13
13.5
1330 1340 1350 1360 ATM 1380 1385
Strike
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Source: Bloomberg, DB FX Research
Skew Analysis
F
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G
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Deutsche Bank@
3
between volatility and spot levels than is observed
then there is a “skew risk premium” This skew risk
premium is in addition to any “insurance premium”
the writer of the put option might charge.

Does USDJPY have a skew?
When we examine the scatter plot of implied
volatility and spot level we see that there is a
negative correlation between spot level and implied
volatility which is statistically significant. This results
in the left tail of the returns being thicker as or a
negative skew as explained above.

What is a risk reversal?
A risk reversal is a contract which is long 1 unit of a
call option (typically 25 delta call option) and short 1
unit of a same delta put option (25 delta put option.
Taking the example of USDJPY, a one month 25
delta risk-reversal would be long a one month 118.34
strike USDJPY call and short a 114.77 strike USDJPY
put. The implied volatility of the call option (mid
market) is 7.43% vs. the put option volatility of
8.03% (spot ref 117.09, ATM volatility 7.6). The
difference between the implied volatilities of options
with different strikes is called the volatility smirk or
smile. This shows that the market price of dollar puts
with roughly the same probability of finishing in the
money is higher than the price of dollar calls with the
same probability of finishing in the money. The
explanation for the price difference between the calls
and the puts follows directly from the explanation
given above about the correlation between spot level
and volatility. Essentially a risk reversal contract helps
take positions on the spot–vol correlation in addition
to a directional bet. Naturally, if the portfolio is delta
hedged continuously then the trade only expresses a
spot-vol correlation view. It can also be thought about
as expressing a dvega/dspot view which means a
small change in the vega of the option portfolio given
a small change in spot level, holding everything else
constant.

How can we see if USDJPY risk reversal is fairly
valued?
Naturally, this leads us to the question if this is
justified. There are two aspects to the question –
first, if the risk reversal is fairly valued with respect to
implied volatility and the second, if the risk reversal is
fairly valued with respect to realized volatility.
Essentially, these questions mean that if the market
participant hedged out the contract such that only
exposure to volatility remained then what kind of
returns would their portfolios show. In one instance
(implied volatility) is how the portfolio would be
marked to market and hence no systematic return
would be made unless there was a correlation
between the spot return and the implied volatility. In
another instance, if the portfolio was held to maturity
then no systematic return would be made less there
were a correlation with realized volatility. In other
words, in the first instance we are testing an
“implied skew” behavior and in the second we test
the “realized skew” behavior.






Fig 3. USDJPY implied volatility smirk means dollar
puts/yen calls are more expensive
USDJPY skew
7
7.5
8
8.5
9
9.5
10P 25P DN 25C 10C
Strikes
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Source: Bloomberg, DB FX Research
Fig 4. USDJPY spot and implied volatility exhibit a
negative correlation in the past sample (1997-2001)
y = -0.1459x + 0.0632
R
2
= 0.0795
-8
-6
-4
-2
0
2
4
6
8
-15 -10 -5 0 5 10 15
1 month change in USDJPY Spot
1

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Fig 5. spot vs. implied volatility negative correlation
continues in the present sample (Jan 2002-Sep 2006)
y = -0.1562x - 0.0509
R
2
= 0.1756
-8
-6
-4
-2
0
2
4
6
8
-15 -10 -5 0 5 10 15
1 month change in USDJPY Spot
1

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Source: Bloomberg, DB FX Research


Is the risk reversal fairly valued with respect to
implied volatility? (USDJPY as an example)
To answer this question, we start with a broad
assumption that a risk reversal is fairly valued if the
implied volatility of a particular strike option remains
constant. Continuing with the example above, say
the USDJPY spot level falls from 117.09 to 114.77,
and the at the money forward volatility increases to
8.03% from 7.6% and similarly, when spot rallies to
118.34 if the at the money volatility goes to 7.43%,
then we consider the risk reversal to be fairly valued.

Naturally this is a rather simple assumption (also
known as sticky by strike). However, given that we
look at the “local” changes in spot every day and the
related changes in implied volatility accompanying it,
this seems to be reasonable. We record the data
sample of spot and implied volatility moves into two
samples - spot up- moves and spot down-moves.

We take the up-moves sample and measure the
change in spot and the related changes in the implied
volatility. We perform a regression to get the
coefficient β
upmove
which tells us how much implied
volatility moves per unit of spot movement up.
Naturally, in case of USDJPY this coefficient is
negative since as spot rallies the implied volatility
usually sells off.

We perform a similar analysis on the down move
sample and get the β
downmove
which is the coefficient of
the change in implied volatility when spot sells off.
Note, that this coefficient will also be negative since a
spot sell off usually results in an implied volatility
rally. To compute the β coefficients we use the data
for the last 3 months. We tried different time windows
for computing the β coefficients and found that the 3
month gave the best results (as measured by the
least amount of squared pricing errors). We then
compute how far out of the money the call and the
put options are (125 pips for the USDJPY call and
232 pips for the USDJPY put in the above example).
And then we calculate the value of the risk reversal
with the following formula





We look at data from January 2000 to August 2006
and find that the risk reversal seems reasonably
correctly valued. There are times when the model
value and the market value of the risk reversal
diverge and those might be trading opportunities. For
example through a large part of 2004 the front end
risk reversals were overvalued with respect to
implied volatility. Any trading strategy based on that
would take advantage of this model valuation to
generate positive returns. As can be seen from fig 6,
our model captures the various movements in the
price of the risk reversal, which is a true test of how
good this simple model is.




















Fig 7. The 10 delta risk reversal is overvalued with
respect to implied volatility

Source: Bloomberg, DB FX Research
Fig 6.The 25 delta risk reversal in the front end is
overvalued
-7.00
-6.00
-5.00
-4.00
-3.00
-2.00
-1.00
-
1.00
2.00
3.00
4.00
Jan-
00
Jun-
00
Nov-
00
Apr-
01
Sep-
01
Feb-
02
Jul-
02
Dec-
02
May-
03
Oct-
03
Mar-
04
Aug-
04
Jan-
05
Jun-
05
Nov-
05
Apr-
06
25del Model Value
25del Price

Source: Bloomberg, DB FX Research
Value of risk reversal = β
upmove*
Out of moneyness
of call - β
downmove
*Out of moneyness of put
Deutsche Bank@
5
Is the risk reversal fairly valued with respect to
realized volatility?
Now we try to answer the question of does the
portfolio of long one unit 25 delta call and short one
unit 25 delta put pay off if held to maturity. Notice, in
the earlier case, we evaluated the question of if spot
moved instantaneously and one were to sell the
portfolio (having hedged all other risks but volatility
risk) then would the return on the portfolio be
positive. In the earlier case the only volatility one
cared about was the implied volatility since we
assume that only a very small interval of time passes
before the portfolio is revalued and hence the
exposure to realized volatility is minimal. Now we
examine if the realized volatility shows any
correlation with the spot levels. In other words is the
realized skew equal to the implied skew of the
distribution.

For this we use some of the well known results in
financial literature from Breeden and Litzenberger
(1978) to infer the risk neutral distribution of the
returns from the option prices. The formula derived
for the relationship between the implied skew and
the risk reversal is as follows:




Here t is the time to maturity and n the evaluation time.

This formula enables us to compute the risk neutral
implied skew from the risk reversal prices. Then we
take the actual log returns of the USDJPY spot and
compute the skew of that distribution. If the returns
were indeed normally distributed, then the skew
should be zero- in other words the distribution should
be symmetric and there should be no correlation
between spot level and volatility. The results in fig. 8
show that the realized skew is always higher than
the implied skew or that in this small sample, the
portfolio produces positive returns. In other words
selling dollar puts and buying dollar calls produces
positive returns for the market maker when the
investor buys “insurance."

Why does being long USD calls / short USD puts
in USDJPY produce a positive return? Implied
volatility has a risk premium built in it in addition to
the future expected realized volatility. The time
period of the data (Apr 03 – July06) is a “small
sample” in that there is no event when the yen
appreciated with a shock.

Essentially, the strategy that systematically sells
dollar puts provides insurance against the possibility
of a big sell off in spot. A deeper question remains- is
the risk premium justified? I.e. is the volatility risk
premium merely a convenience cost (i.e.







Fig 10. And naturally the realized risk reversal has a
higher value than the implied
USDJPY Realized vs. Implied Risk reversal
-4.00
-3.00
-2.00
-1.00
0.00
1.00
2.00
M
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0
6
Realized Riskie Implied Risk Reversal


Source: Bloomberg, DB FX Research
Fig 8. Realized volatility and spot had a similar
negative relationship from 1997-2001
y = -0.3364x + 0.0625
R
2
= 0.0488
-8
-6
-4
-2
0
2
4
6
8
-15 -10 -5 0 5 10 15
1 month change in mean USDJPY Spot
1

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Source: Bloomberg, DB FX Research
Fig 9. However, since 2002 this relationship has
broken down
y = 0.0252x + 0.0106
R
2
= 0.0006
-8
-6
-4
-2
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4
6
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-15 -10 -5 0 5 10 15
1 month change in mean USDJPY Spot
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Source: Bloomberg, DB FX Research
Skew
t,n
= 4.4478* RiskReversal
t,n
(25)/At The
Money Volatility
t,n


the amount of money you pay to not have to
synthetically manage your portfolio to create a call
option) or is there a covariance with a risk factor
involved. An interesting insight is that yen rallies,
carry trade unwinds and bouts of risk aversion are all
correlated. Naturally, when the market is more risk
averse, it is willing to pay a higher “insurance
premium” for the same risk. However, the central
question remains- What is the real macroeconomic
risk? – an example could be a global recession risk
due to a US current account deficit.

How can we use variance swaps to take
advantage of the “risk premium?” The data makes
us think that a smart way to trade yen volatility would
be to be long only implied volatility and skew and sell
the realized volatility and skew.

A simple variance swap pay off is just the difference
between the implied and realized variance.




Now structures like the conditional variance swap
utilize the spot and volatility correlation to improve
the volatility break even and the contract is
structured as follows:


Mathematically the pay off can be expressed as:






Here if i-1’th spot fixing is below the level H then
H S
i
<
−1
1
= 0 and if it is above then = 1

How do the suggested trades take advantage of
the “risk premium?”
The short conditional variance swap leg enables
selling the realized volatility when spot sells off,
which is usually lower than the market implied
volatility and has little relation to spot level.
Essentially, the conditional variance swap collects the
risk premium when spot sells off, which is results in
positive returns. In a low volatility environment a
conditional variance swap is an ideal way to leverage
a core view that volatility will pick up over the coming
months.

Any increase in the “uncertainty” or increase in risk
premium as spot sells off or due to some macro
economic event will also favor this trade since
typically higher the risk aversion, the higher the
premium we collect and hence the better the strike
improvement. The BoJ’s stance on interest rates also
helps us determine the feasibility of the trade. As the
BoJ looks unlikely to raise rates soon, we are
confident of low realized volatility in the near future.
Not unnaturally, the carry trade is back.

In the rest of this piece we examine risk reversal
value for other G10 currency pairs.









































2 2
Payoff
Strike Realised
σ σ − =

= −
<
¦
)
¦
`
¹
¦
¹
¦
´
¦

|
|
.
|

\
|

=

N
i i
i
H S
S
S
N
i
1
2
2
1
log 252 1
1
1
Payoff
1
σ
• If spot remains above 114 the variance
swap works in the usual way
• If spot moves below 114, fixings below
114 do not contribute to the variance
calculation
• Strike improvement of 0.6 vols from
8.85% to 8.25% in 1 year maturity
Deutsche Bank@
7
EURUSD

At the moment, our model says that the EURUSD
front end risk reversals which just switched sign
from being positive to negative at -0.2 vols for EUR
puts are slightly expensive. The back end (=1 year)
risk reversal at 0.35 vols is also somewhat over
priced with respect to implied volatility although it
has been tending towards fair value. The 1m 25 delta
strikes are 1.2380 and 1.2720 for vols of 6.8 and 6.55
respectively. We expect the implied to rally if spot
goes to 1.2380 and to sell off if spot retraces back to
1.2720 and be lower. However, we believe that the
market is overestimating the possibility of a “regime
shift” once more after a sharp spot move. So our
view is that the front end risk reversals are
somewhat overvalued.

Our analysis of risk reversal with respect to realized
volatility indicates that it is overvalued. The other
general finding is that risk reversals rarely pay for
themselves if they are higher than 0.5 vols. Unless,
we expect a big macro shock, we would prefer to be
a seller rather than a buyer at those levels. When we
have sharp and persistent divergences from the
model in the front or the back end it implies a trading
opportunity. When the risk reversal price produced
by the model consistently provides a value above the
current price, it means that the risk reversals are
“cheap.”- For example, at the moment EURUSD 1m
risk reversals are cheap.

Historically, in the middle of 2002 the risk reversals
were cheap with respect to implied volatility. That
pattern continued through that year and gradually
they returned to fair value in 2003.

Looking at EURUSD spot we see three main
regimes. Before 2002 EURUSD was in a downward
trend and after 2002 it was in an uptrend that lasted
until 2005. Since then it has traded sideways and is
in what we classify as the third regime. We observe
that risk reversals tend to trend with spot values. In
the first EUR bearish regime any spot moves lower
meant an increase in implied volatility. There was a
regime change in 2002, during which the risk
reversal changed from favoring EUR downside to
EUR upside and in the second regime EURUSD
moves up meant an increase in implied volatility. In
the third regime of EURUSD trading sideways we
see that EURUSD risk reversals are fairly valued and
spot increases still mean implied volatility increases.

















Fig 11. From 1999-2002 EUR puts were better bid
and if spot fell, implied volatility rallied
y = -9.6956x - 0.0497
R
2
= 0.0355
-5
-4
-3
-2
-1
0
1
2
3
4
5
-0.20 -0.10 0.00 0.10 0.20
1 month change in EURUSD Spot
1

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Source: Bloomberg, DB FX Research
Fig 12. EURUSD spot “regime” change in 2002 led to
EUR calls being more expensive
EURUSD spot rate
0.8
0.9
1
1.1
1.2
1.3
1.4
1.5
J
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9
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J
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J
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0
6


Source: Bloomberg, DB FX Research
Fig 13. Front End EURUSD risk reversals are slightly
overvalued with respect to implied volatility
-8.00
-6.00
-4.00
-2.00
-
2.00
4.00
6.00
Jan-
00
Jun-
00
Nov-
00
Apr-
01
Sep-
01
Feb-
02
Jul-
02
Dec-
02
May-
03
Oct-
03
Mar-
04
Aug-
04
Jan-
05
Jun-
05
Nov-
05
Apr-
06
Sep-
06
25 del Model Value
25 del Price
Source: Bloomberg, DB FX Research


GBPUSD

GBP risk reversals have just flipped direction from
being bid for sterling calls to being bid for sterling
puts. They had been bid for sterling calls since 2001
when spot started trending higher. At the moment,
with the 1 month risk reversal at -0.18 favoring
downside, we think that the market has overreacted
with respect to the dollar rally and the probability of a
sharp dollar up move is less than implied by the risk
reversal. We agree that any GBPUSD rally is more
likely to result in spot being back in the “range”
which is bearish volatility, however according to our
model the odds are higher that the dollar up move is
subdued than is currently implied by the distribution.

At the moment we prefer to sell the USD calls and
buy USD puts and then wait to buy them back for a
small profit when the market prices in a lower
chance of a spot break and the risk reversal price
comes down. Until recently, the back end risk
reversals which were priced at 0.30 vols seemed
overvalued with respect to implied volatility.
However, with the recent move down to 0.2250 they
have come closer to being fairly valued.

Historically, GBPUSD implied volatility has rallied with
spot rallies, however realized volatility rarely tends to
follow. Although, GBPUSD traded sideways and then
mostly downward from 1996 to 2002, implied
volatility still rallied when spot moved up. This
indicates to us that the market might have been
overpricing the risk reversals in that period, or
attaching a large risk premium to a large dollar move
downward.

Notice, that the realized volatility and spot levels
display no significant relationship during the current
sample period of 1999-2005. This led to the realized
skew being quite low and hence the realized risk
reversal was overvalued for most of the 1999-2005
period. The simplest way to formulate a trading
strategy, based on the risk reversal model is to
examine periods when the model valuation is
significantly and persistently different from the actual
valuation. Naturally, if the model values are higher
than the risk reversal values, we like buying and if the
model values are lower than the current risk reversal
values, we like selling. For example in GBPUSD, we
note that in Sep 2002 buying risk reversals (buy GBP
calls / sell GBP puts) would have generated
substantial positive returns, as would have selling
them (sell GBP calls / buy GBP puts) in November
and December 2003.

When spot is in a trending cycle then risk reversals
tend to be have higher values, which may be
ascribed to overvaluation or possibly a higher risk


premium on a spot move up. In times of sideways
movement risk reversals tend to be reasonably
correctly valued, perhaps because people are
unwilling to buy vanilla options when they see
realized volatility being low and the expected realized
volatility in the near future is low as well. With little
speculative interest and little realized volatility the
price of the risk reversal decreases. Interestingly we
notice the pattern that the front end risk reversal is
close to fair value in these situations. However,
notice that the back end of the risk reversal is still
slightly overvalued according to the model. This
probably reflects a term structure of risk premium
which is upward sloping or liquidity and hedging
costs. Additionally, for this currency pair also we find
that when the risk reversals price gets to more than
0.5 vols they rarely tend to pay for themselves.





Fig. 14. The implied vol and spot correlation have a
positive relationship
y = 5.8963x - 0.0496
R
2
= 0.0927
-5
-4
-3
-2
-1
0
1
2
3
4
5
-0.20 -0.10 0.00 0.10 0.20
1 month change in GBPUSD Spot
1

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1
m

I
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Source: Bloomberg, DB FX Research
Fig. 15. However, GBPUSD realized volatility has
shown no correlation to realized spot movements
y = -3.3271x + 0.0353
R
2
= 0.0022
-6
-4
-2
0
2
4
6
-0.15 -0.10 -0.05 0.00 0.05 0.10 0.15
1 month change in mean GBPUSD Spot
1

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Source: Bloomberg, DB FX Research
Deutsche Bank@
9
NZDUSD

With the exception of USDJPY and the yen crosses,
NZDUSD exhibits the most extreme risk reversals in
the G10 FX world, between 0.5 and 1 vol favoring
kiwi puts.

The market preference for puts on the kiwi dollar is
due to the currency’s position as the highest yielder
in the G10. With 1 year rates above 7.5%, long kiwi
dollar positions are naturally very popular with FX
carry traders. During bouts of risk aversion, these
carry trades are unwound dramatically and the
currency lurches lower, causing higher actual
volatility and higher implied volatility as traders
scramble to buy gamma to cover their positions.

We find that in our model, front end risk reversals are
undervalued with respect to moves in implied
volatility. However, as we shift to longer dated risk
reversals, we find that the market overestimates the
change in implied volatility when spot changes.
Additionally, as seen in fig. 17, the realized skew of
the NZDUSD distribution is a lot less negative in our
sample than implied by the value of the risk reversal.
This suggests the back-end Kiwi risk reversals are
overvalued both in terms of implied and realized
volatility moves.

This overvaluation becomes most apparent after the
early 2004 drawdown of 2003 carry trade (NZDUSD
up 30% in ’03). Since mid 2004, rises in US rates
have reduced the interest rate differential and
removed the attraction of USD of a funding currency
thus reducing the interest in the NZDUSD carry
trade. The NZDUSD realized skew exceeded the
implied skew for a brief period when the NZD fell
sharply but it seems the longer dated risk reversals
priced in a “regime change” of falling spot and hence
they have not been worth it subsequently as they
have remained around 0.75 vols since 2004.
























Fig 16. Realized skew is not as negative as implied
skew. Risk reversals rarely pay for themselves if
they exceed 0.5 vols
-2.50
-2.00
-1.50
-1.00
-0.50
0.00
0.50
1.00
1.50
2.00
2.50
Jan-
98
Aug-
98
Mar-
99
Oct-
99
May-
00
Dec-
00
Jul-
01
Feb-
02
Sep-
02
Apr-
03
Nov-
03
Jun-
04
Jan-
05
Aug-
05
Mar-
06
Realized Riskie Implied Risk Reversal

Source: Bloomberg, DB FX Research
Fig 18. NZDUSD front end risk reversal is
undervalued with respect to implied volatility
-3.00
-2.50
-2.00
-1.50
-1.00
-0.50
-
0.50
1.00
1.50
2.00
Jan-
00
Jul-
00
Jan-
01
Jul-
01
Jan-
02
Jul-
02
Jan-
03
Jul-
03
Jan-
04
Jul-
04
Jan-
05
Jul-
05
Jan-
06
Jul-
06
25 del Model Value
25 del Price
Source: Bloomberg, DB FX Research
Fig 17. Back End NZDUSD risk reversals are
overvalued with respect to implied volatility
-1.50
-1.00
-0.50
-
0.50
1.00
Jan-
00
Jul-
00
Jan-
01
Jul-
01
Jan-
02
Jul-
02
Jan-
03
Jul-
03
Jan-
04
Jul-
04
Jan-
05
Jul-
05
Jan-
06
Jul-
06
25 del Model Value
25 del Price

Source: Bloomberg, DB FX Research


GBPJPY

Like any other carry trades, GBPJPY risk reversals
are bid for downside with investors demanding
protection for long cash positions. The 1m risk
reversal is priced at -0.6 vols and the one year is -
0.72 vols. At these levels both the front end and back
end risk reversals seem overvalued with respect to
implied volatility.

Also, on average the risk reversal rarely pays for itself
in GBPJPY. We find that while there is a significant
negative relationship between implied volatility and
spot levels, there is no significant relationship
between the spot moves and the changes in the
realized volatility (from 2002- today, fig. 21). Naturally,
this results in the skew implied by the distribution
having a much more negative value than the actual
skew in the realized distribution.

Like other currency pairs analyzed before, spot
trends have definitely driven the risk reversal prices
in this currency pair as well. There was a big sell off
in GBPJPY spot in the year 2000 when GBPJPY went
from around 179 to 148.72 and since then there have
been several small sharp sell offs. We think that
these sharp “crashes” might cause a market “crash”
risk premium. For a certain amount of time, the risk
reversal more than pays for itself and after that the
“risk premiums” turn more negative and the risk
reversal becomes overvalued.

This dynamic leads us to suggest conditional variance
swaps or premium collecting trades for this currency
pair.































Fig 22. GBPJPY realized risk reversal has usually
exhibited a less negative skew than implied
Realized vs. Implied Risk reversal
-5.00
-4.00
-3.00
-2.00
-1.00
0.00
1.00
2.00
3.00
4.00
5.00
F
e
b
-
9
9
A
u
g
-
9
9
F
e
b
-
0
0
A
u
g
-
0
0
F
e
b
-
0
1
A
u
g
-
0
1
F
e
b
-
0
2
A
u
g
-
0
2
F
e
b
-
0
3
A
u
g
-
0
3
F
e
b
-
0
4
A
u
g
-
0
4
F
e
b
-
0
5
A
u
g
-
0
5
F
e
b
-
0
6
A
u
g
-
0
6
Realized Riskie
Implied Risk Reversal


Source: Bloomberg, DB FX Research
Fig 20. Back End GBPJPY risk reversals are over
valued with respect to implied volatility
-3.00
-2.00
-1.00
-
1.00
2.00
3.00
4.00
5.00
6.00
7.00
8.00
Jan-
00
Jul-
00
Jan-
01
Jul-
01
Jan-
02
Jul-
02
Jan-
03
Jul-
03
Jan-
04
Jul-
04
Jan-
05
Jul-
05
Jan-
06
Jul-
06
25 del Model Value
25 del Price

Source: Bloomberg, DB FX Research
Fig 21. GBPJPY realized volatility shows no
relationship with spot moves in our sample
y = -0.0528x - 0.0784
R
2
= 0.0053
-6
-4
-2
0
2
4
6
-5.00 -3.00 -1.00 1.00 3.00 5.00
1 month change in mean GBPJPY Spot
1

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Source: Bloomberg, DB FX Research
Deutsche Bank@
11

AUDJPY

AUDJPY has consistently been one of the most
popular carry pairs due to the high Australian interest
rates (6.4%) and the low Japanese interest rates
(0.66%). With a history of frequent and sharp sell
offs, for example in 2000, AUDJPY went from around
71 to 55.99; this pair exhibits a significant skew- 1
month 25 risk reversal is valued at -0.95 vols and the
one year is -1.5 vols. It is also a reasonable argument
that this implied skew includes a “crash premium.”
At these levels the front end risk reversals are fairly
valued with respect to implied volatility but the back
end risk reversals are overvalued with respect to the
implied volatility.

As expected, the realized skew of the return
distribution is consistently less negative or less on an
absolute value basis than is implied by the value of
the risk reversal contract. This means that the risk
reversal is overvalued with respect to realized
volatility.

When we glance at the charts we notice that
AUDJPY follows the typical yen cross sell off pattern-
sell off happens, short and long end implied risk
reversals widen considerably, for a short period of
time front end risk reversal pays for itself and then
gradually it becomes more expensive, while the back
end risk reversal frequently doesn’t pay for itself
(esp. if kept to maturity). We like buying 6 month
AUDJPY variance swaps at 7.8% while the regular
var swap is at 8.15%. In this case the fixings below
87 will not count towards the var swap calculation.

















Fig 23. Naturally, AUDJPY has a negative
relationship between spot and implied volatility
y = -0.2357x + 0.0234
R
2
= 0.1622
-2
-2
-1
-1
0
1
1
2
2
-3.00 -2.00 -1.00 0.00 1.00 2.00 3.00
1 month change in AUDJPY Spot
1

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Source: Bloomberg, DB FX Research
Fig 24. Front end AUDJPY risk reversals seem fairly
valued with respect to implied volatility
-5.00
-4.00
-3.00
-2.00
-1.00
-
1.00
2.00
3.00
Jan-
00
Jul-
00
Jan-
01
Jul-
01
Jan-
02
Jul-
02
Jan-
03
Jul-
03
Jan-
04
Jul-
04
Jan-
05
Jul-
05
Jan-
06
Jul-
06
25 del Model Value
25 del Price

Source: Bloomberg, DB FX Research
Fig. 26. AUDJPY realized skew is consistently less
negative than the implied skew
Realized vs. Implied Risk reversal
-3.00
-2.00
-1.00
0.00
1.00
2.00
3.00
M
a
r
-
9
9
S
e
p
-
9
9
M
a
r
-
0
0
S
e
p
-
0
0
M
a
r
-
0
1
S
e
p
-
0
1
M
a
r
-
0
2
S
e
p
-
0
2
M
a
r
-
0
3
S
e
p
-
0
3
M
a
r
-
0
4
S
e
p
-
0
4
M
a
r
-
0
5
S
e
p
-
0
5
M
a
r
-
0
6
S
e
p
-
0
6
Realized Riskie
Implied Risk Reversal
Source: Bloomberg, DB FX Research
Fig 25. Back End AUDJPY risk reversal has been
consistently overvalued according to the model
-5.00
-4.00
-3.00
-2.00
-1.00
-
1.00
2.00
3.00
Jan-
00
Jul-
00
Jan-
01
Jul-
01
Jan-
02
Jul-
02
Jan-
03
Jul-
03
Jan-
04
Jul-
04
Jan-
05
Jul-
05
Jan-
06
Jul-
06
25 del Model Value
25 del Price
Source: Bloomberg, DB FX Research



AUDUSD

AUDUSD 1m risk reversal is -0.5 vol and the back
end is -0.57 vols. At these levels the front end risk
reversals are fairly valued with respect to implied
volatility while the longer dated risk reversal
contracts seem overvalued with respect to implied
volatility. The risk reversal is overvalued with respect
to realized volatility (fig 30) so we like collecting the
risk premium via instruments like conditional variance
swaps.

We see that spot and implied volatility have a slight
negative correlation. The spot trend and risk reversal
pricing dynamics work similar to other currency pairs.
We find that as AUDUSD rallied steadily from 0.63 to
0.80 from 2002 to 2003 risk reversals went bid for
AUD calls, reflecting a spot regime change. Again,
we notice that the implied distribution seems to
overestimate the skew present in the realized return
distribution.

Also, in keeping with the big spot move leading to
risk reversal overvaluation, we observe that the back
end risk reversal became “overvalued” with respect
to implied volatility after we saw a massive sell off in
AUDUSD spot in end of 2003 to the middle of 2004.






















Fig 27. AUDUSD front end risk reversals seem fairly
valued with respect to implied volatility
-3.00
-2.50
-2.00
-1.50
-1.00
-0.50
-
0.50
1.00
1.50
2.00
2.50
Jan-
00
Jul-
00
Jan-
01
Jul-
01
Jan-
02
Jul-
02
Jan-
03
Jul-
03
Jan-
04
Jul-
04
Jan-
05
Jul-
05
Jan-
06
Jul-
06
25 del Model Value
25 del Price
Source: Bloomberg, DB FX Research
Fig 29. AUDUSD back end risk reversals seem over
valued with respect to implied volatility
-1.40
-1.20
-1.00
-0.80
-0.60
-0.40
-0.20
-
0.20
0.40
0.60
Jan-
00
Jul-
00
Jan-
01
Jul-
01
Jan-
02
Jul-
02
Jan-
03
Jul-
03
Jan-
04
Jul-
04
Jan-
05
Jul-
05
Jan-
06
Jul-
06
25 del Model Value
25 del Price


Source: Bloomberg, DB FX Research
Fig. 30. AUDUSD realized risk reversal has been
consistently less negatively skewed than the implied
Realized vs. Implied Risk reversal
-2.00
-1.00
0.00
1.00
2.00
3.00
4.00
F
e
b
-
9
8
A
u
g
-
9
8
F
e
b
-
9
9
A
u
g
-
9
9
F
e
b
-
0
0
A
u
g
-
0
0
F
e
b
-
0
1
A
u
g
-
0
1
F
e
b
-
0
2
A
u
g
-
0
2
F
e
b
-
0
3
A
u
g
-
0
3
F
e
b
-
0
4
A
u
g
-
0
4
F
e
b
-
0
5
A
u
g
-
0
5
F
e
b
-
0
6
A
u
g
-
0
6
Realized Riskie
Implied Risk Reversal

Source: Bloomberg, DB FX Research
Fig 28. AUDUSD spot and implied volatility have a
slightly negative correlation
y = -6.7021x - 0.0123
R
2
= 0.017
-3
-2
-1
0
1
2
3
-0.10 -0.05 0.00 0.05 0.10
1 month change in AUDUSD Spot
1

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Source: Bloomberg, DB FX Research
Deutsche Bank@
13
USDCAD

USDCAD 1m risk reversal at 0.1 vol and 1y at 0.07
vol is fairly valued with respect to implied and
realized volatility. The spot and implied volatility have
a slight negative correlation which is not very stable
through time which means that the risk reversals flip
signs from positive to negative frequently.In general,
we observe that whenever spot is trading within a
range the front end risk reversals are usually fairly
priced, However, when spot breaks out of range
then the risk reversal contracts become bid in that
direction. For example if USDCAD rallies and breaks
the range then the risk reversal is bid for USD calls
and if USDCAD sells off and breaks the range then
CAD calls are more expensive.

Essentially the idea of the market “over reaction”
seems to be prevalent. However, for a short period
of time the risk reversals do pay for themselves as –
for example in May 2002 the risk reversals more than
paid for themselves. However, in June 2003 the risk
reversals were overvalued in 2003 as USDCAD had a
sharp decline and the risk reversal went bid for CAD
puts. Like other currency pairs in USDCAD risk
reversal also, we find that it is easier to sell into the
rallies by using the model carefully to find a
persistent overvaluation the market.

This “overvaluation” seems to result from an
overestimation of the probability of the sharp spot
move continuing.






















Fig 34. USDCAD spot and implied volatility have a
slightly negative correlation which is not very stable
y = -2.8797x + 0.0068
R
2
= 0.0127
-3
-2
-1
0
1
2
3
-0.10 -0.05 0.00 0.05 0.10
1 month change in USDCAD Spot
1

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V
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a
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i
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y
Source: Bloomberg, DB FX Research
Fig 31. USDCAD implied and realized skew are
usually close to each other and fairly valued
Realized vs. Implied Risk reversal
-1.50
-1.00
-0.50
0.00
0.50
1.00
1.50
F
e
b
-
9
8
A
u
g
-
9
8
F
e
b
-
9
9
A
u
g
-
9
9
F
e
b
-
0
0
A
u
g
-
0
0
F
e
b
-
0
1
A
u
g
-
0
1
F
e
b
-
0
2
A
u
g
-
0
2
F
e
b
-
0
3
A
u
g
-
0
3
F
e
b
-
0
4
A
u
g
-
0
4
F
e
b
-
0
5
A
u
g
-
0
5
F
e
b
-
0
6
A
u
g
-
0
6
Realized Riskie
Implied Risk Reversal
Source: Bloomberg, DB FX Research
Fig 32. USDCAD front end risk reversals are faily
valued with respect to implied volatility
-1.50
-1.00
-0.50
-
0.50
1.00
1.50
Jan-
00
Jul-
00
Jan-
01
Jul-
01
Jan-
02
Jul-
02
Jan-
03
Jul-
03
Jan-
04
Jul-
04
Jan-
05
Jul-
05
Jan-
06
Jul-
06
25 del Model Value
25 del Price
Source: Bloomberg, DB FX Research
Fig 33. USDCAD back end risk reversals are fairly
valued at the moment
-1.00
-0.80
-0.60
-0.40
-0.20
-
0.20
0.40
0.60
0.80
Jan-
00
Jul-
00
Jan-
01
Jul-
01
Jan-
02
Jul-
02
Jan-
03
Jul-
03
Jan-
04
Jul-
04
Jan-
05
Jul-
05
Jan-
06
Jul-
06
25 del Model Value
25 del Price
Source: Bloomberg, DB FX Research


EURCHF

EURCHF implied volatility and spot show a slight
negative correlation and the 1m risk reversals are
priced at -0.05 vols which means that they are almost
“flat” (i.e. call and put have almost similar implied
volatilities). At this level the front end risk reversals
are fairly valued with respect to implied volatility (fig.
35). The flat level implies that the spot has not had a
massive trend so it is not a surprise that it is “fair
value.” However, the back end risk reversal at -0.125
vol is slightly overvalued (fig 37) and the actual skew
is consistently less on an absolute value basis than
what is implied by the distribution derived from the
risk reversal contract.

Again, we see that EURCHF spot shows the classic
sharp sell off and slower rallies up, which like the
previous currency pairs, means that the implied skew
is likely to be more negative and the longer term risk
reversals are more likely to be “overvalued”
Additionally, since in CHF crosses there is the belief
of CHF being a crisis currency, longer dated CHF
calls might be seen as providing insurance.























Fig 35. EURCHF front end risk reversals are fairly
valued at the moment
-3.00
-2.50
-2.00
-1.50
-1.00
-0.50
-
0.50
1.00
Jan-
00
Jul-
00
Jan-
01
Jul-
01
Jan-
02
Jul-
02
Jan-
03
Jul-
03
Jan-
04
Jul-
04
Jan-
05
Jul-
05
Jan-
06
Jul-
06
25 del Model Value
25 del Price


Source: Bloomberg, DB FX Research
Fig 38. EURCHF implied volatility and spot show a
slight negative correlation
y = -7.1506x - 0.01
R
2
= 0.0314
-2
-2
-1
-1
0
1
1
2
2
-0.05 -0.03 -0.01 0.01 0.03 0.0
1 month change in EURCHF Spot
1

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Source: Bloomberg, DB FX Research
Fig 37. EURCHF back end risk reversal is over valued
according to the model
-2.00
-1.50
-1.00
-0.50
-
0.50
1.00
Jan-
00
Jul-
00
Jan-
01
Jul-
01
Jan-
02
Jul-
02
Jan-
03
Jul-
03
Jan-
04
Jul-
04
Jan-
05
Jul-
05
Jan-
06
Jul-
06
25 del Model Value
25 del Price

Source: Bloomberg, DB FX Research
Fig 36. EURCHF realized skew is consistently less
negative than the implied skew
Realized vs. Implied Risk reversal
-2.00
-1.50
-1.00
-0.50
0.00
0.50
1.00
1.50
2.00
J
a
n
-
9
9
J
u
l-
9
9
J
a
n
-
0
0
J
u
l-
0
0
J
a
n
-
0
1
J
u
l-
0
1
J
a
n
-
0
2
J
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Implied Risk Reversal

Source: Bloomberg, DB FX Research
Deutsche Bank@
15
EURJPY

EURJPY has similar characteristics to USDJPY and
other yen crosses; essentially there is a stable
negative relationship between spot and implied
volatility. The front end risk reversal is overvalued
(fig. 39) with respect to implied volatility. Similarly,
the back end risk reversal is overvalued and we
notice that the skewness implied by the distribution
is more (on an absolute value basis) than what is
realized in actual returns.

The implied and realized skew become less negative
in the end of 2000 and beginning of 2001 as EURJPY
rallied sharply resulting in the implied and realized
skew changing across all models. Since then,
EURJPY has experienced a steady uptrend and
occasional sharp draw-downs. In 2003 EURJPY
experienced sharp down moves and naturally the
back end risk reversal in EURJPY suddenly became
overvalued after 2003 due to the “insurance
premium” attached to the possibility of another sharp
down move.

After the sharp down move it is also interesting how
even in the front end risk reversal the implied and
realized skew diverge due to the addition of the “risk
premium”. In our opinion it is these drawdowns that
provide a good trading opportunity, either via buying
the risk reversal or via conditional variance swaps.
These are reflected by our model - we see that the
model line is consistently closer to zero as compared
to the actual price of the risk reversal almost through
the life of the model (refer to chart).



















Fig 41. EURJPY realized skew has been consistently
less negative than implied by the risk reversals
Realized vs. Implied Risk reversal
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Source: Bloomberg, DB FX Research
Fig 39. EURJPY front end risk reversal is overvalued
according to the model
-4.00
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25 del Model Value
25 del Price

Source: Bloomberg, DB FX Research
Fig 38. EURJPY has exhibited negative correlation of
spot and implied volatility from 2002- today
y = -0.111x - 0.0125
R
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= 0.0954
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Source: Bloomberg, DB FX Research
Fig 40. Back end EURJPY risk reversal has been
consistently overvalued wrt implied volatility
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Source: Bloomberg, DB FX Research


USDCHF

As a “safe haven” currency CHF, typically rallies in
times of crisis. Usually, in times of crisis implied
volatility shoots up also. Thus we find that USDCHF
spot and implied volatility have a stable negative
correlation.

The 1m (front end) risk reversal is bid 0.30 for USD
calls and we think they are overvalued (fig. 43) Once
again, this is a function of the market reasoning that
there will be a sharp dollar up move and as spot
breaks out of range the volatility will go bid. We
agree with the logic presented, but disagree with the
probability of the sharp dollar move. We think that
the probability of the sharp dollar move up is
considerably less than implied by the risk reversal
distribution.

The back end risk reversals have come in over the
last two weeks from -0.45 vols (bid for CHF puts) to
-0.23 for CHF puts which is much closer to fair value
with respect to implied volatility (fig 44).There is a
possible argument that they might have a risk
premium built in and hence might seem more
“overvalued.”

With the implied and realized skew of the front end
risk reversal close to zero , this risk reversal also
seems fairly valued with respect to realized volatility.
However when we examine the back end for implied
vs. realized skew, we find that the risk reversal is
overvalued with respect to realized volatility. Our
preferred trade in USDCHF would be to buy the back
end risk reversal in times of a crisis and collect the
crisis premium.













Fig 44. USDCHF back end risk reversal is slightly
overvalued
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Source: Bloomberg, DB FX Research
Fig 43. USDCHF front end risk reversal is overvalued
valued according to the model
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25 del Model Value
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Source: Bloomberg, DB FX Research
Fig 45. USDCHF realized skew is close to the skew
implied from the risk reversals
Realized vs. Implied Risk reversal
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Source: Bloomberg, DB FX Research
Fig 42. USDCHF spot and implied volatility have a
stable negative correlation
y = -11.684x - 0.1076
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Source: Bloomberg, DB FX Research
Deutsche Bank@
17
Analysis of the risk reversal model

We observe a few systematic patterns from our
skew valuation models. Below we discuss and
summarize the observations of valuations with
respect to implied and realized volatility and also note
possible improvements to the model.

Observations about the risk reversal valuation
with respect to implied volatility

• When spot is trading in a range, front end
risk reversals tend to be close to fair value
with respect to implied volatility as the
market seems quite good at pricing the risk
reversal with respect to implied volatility
during those times. We don’t observe many
systematic trading opportunities, however
from time to time we find that risk reversals
become over or undervalued.
• A sharp spot movement usually results in the
front end risk reversal paying for itself for
some time but then the market begins to
“overestimate” the volatility changes with
respect to spot movement. At that point we
find the front end risk reversal contract
becoming overvalued with respect to implied
volatility. These result in the most systematic
trading opportunities of selling the
overvalued risk reversal.
• The effect of a sharp spot movement on
back end risk reversals is greater. The back
end risk reversals seem to have a higher
tendency to become “overvalued” with
respect to implied volatility and remain that
way for longer periods. It seems that the
market usually “overestimates” the
magnitude and the life of the trend and
prices in a “regime shift” The back end of
the risk reversal is usually slightly overvalued
according to the model. However, the back
end overvaluation could also reflect a term
structure of “risk premium” which is upward
sloping.
• We find the overvaluation effects to be
exacerbated in case of carry currencies.
Usually, many market participants are
invested in the carry trade. These currency
pairs experience sharp declines and hence
these investors bid up the prices of the lower
interest rate currency calls as they all want to
buy “protection.” So after the carry currency
pair experiences a sharp sell off, the
investors attach a higher subjective
probability of a sell off happening again.



Observations about risk reversal valuation with
respect to realized volatility

• We observe that the realized skew of the
return distribution is less on an absolute
value basis in most currency pairs than
implied by the risk reversal contracts.
• We observe that the difference between the
realized and implied skew is more substantial
in the higher carry currencies. We think a
similar explanation of the “crash risk
premium” drives the difference in the
realized and implied skew.
• In the event of a sharp spot movement the
realized skew exceeds the implied skew for
a certain period of time and the risk reversal
“pays for itself.” However, after the event
the implied skew continues to be higher and
the market overestimates the possibility of
the regime shift continuing and also
becomes more willing to pay the insurance
premium via the difference between the
implied and the realized skew.
• A good (but rough) rule of thumb is that risk
reversals rarely pay for themselves when
they are above 0.5 vols.

Further improvements to the model

With our model, we are inherently subscribing to
some sort of a linear relationship between spot
and volatility which is closer to a Heston type
stochastic volatility model (although we allow for
the correlation to vary across time) than a local
volatility model. There is no theoretical reason at
all for the spot and volatility relationship to be
linear. However, given that we look at daily
changes and do separate the upmoves from the
down moves we have eliminated the first order
issues with assuming the relationship to be
linear. To be theoretically more correct we
should have a volatility and spot relation model
for every currency pair, which would then be
calibrated to fit the various market observed
option prices and end up as a time varying mix of
local and stochastic volatility model and we
would simulate the path taken by spot and then
estimate the returns of our investment strategies
to really capture the risk reversal value with
respect to both implied and realized volatility. All
this will naturally require considerable calibration
and computation. That seems impractical at this
stage.

Additionally, we still need to uncover the
“macroeconomic” or consumption based asset
price factor that underpins the purported risk
premium- remember that in any standard asset


pricing model such as the CAPM, the ICAPM or
APT, we need covariance with the consumption
portfolio (proxied by various “factors” usually).
The issue of the risk premium in currencies
remains a thorny one and as practitioners, we are
interested in the “basic risk factors” as long as
they either help us in hedging them or in terms
of any predictive or return explanatory powers.

However, there are other easier and more fruitful
improvements at hand. We could correct for
constant interest rate assumptions in our model.
We could also make some distributional
assumptions about the skewed currency pairs,
while computing the realized skew. Obviously,
any departure from normality costs computation
times and increases complexity.

Yet another application of the skew analysis
could be to use them in conjunction with the
carry trade(s) since they appear to be closely
related. It would also be interesting to extend
this analysis to emerging markets since the “risk
factors” there are more apparent.

On another front, we could develop a cross
sectional model that would enable us to compare
risk reversals across currency pairs and identify
common characteristics leading to risk reversal
portfolio opportunities or trading models. A cross
sectional model using a spot range breakout
indicator, interest rate differential, country default
probability and current account deficits might be
an interesting extension.








Currency Pair Risk Reversal*
EURUSD Overvalued
GBPUSD Overvalued
NZDUSD Undervalued
GBPJPY Overvalued
AUDJPY Fairly valued
AUDUSD Fairly valued
USDCAD Fairly valued
EURCHF Fairly valued
EURJPY Overvalued
USDCHF Overvalued
USDJPY Overvalued
Risk Reversal Summary Table

















This has been prepared solely for informational purposes. It is not an offer,
recommendation or solicitation to buy or sell, nor is it an official confirmation
of terms. It is based on information generally available to the public from
sources believed to be reliable. No representation is made that it is accurate
or complete or that any returns indicated will be achieved. Changes to
assumptions may have a material impact on any returns detailed. Past
performance is not indicative of future returns. Price and availability are
subject to change without notice. Additional information is available upon
request.
Dedicated to Mom, Rachel and Manu
*1m risk reversal valued wrt implied vol

Risk reversals are liquid instruments that allow exposure to this correlation between volatility and spot levels.5 10 1330 1340 1350 1360 Strike ATM 1380 1385 Source: Bloomberg. The lighter distribution is referred to as a negatively skewed distribution. which is an approximation of the probability of the option finishing in the money. falls in equity prices are accompanied by sharp increases in volatility. Out of money puts and deep in the money calls in equities are more expensive S&P 500 Dec 2006 Option Strike vs.FX Relative Value Skew Analysis • We link skewness of the FX spot return distribution to the risk reversal contract and propose a methodology to value risk reversal with respect to implied and realized volatility to find relative value trading opportunities In most cases realized skew is less on an absolute value basis than the implied skew We also observe that a sharp movement in spot is usually followed by a risk reversal “overvaluation” as “risk premium” increases and implied skew in the following periods is higher than realized skew. the lighter distribution has a left tail that is heavier than the darker colored normal distribution. This phenomenon of skew has been observed in other markets as well To the extent that implied and realized distributions diverge systematically and consistently. In the case of equity indices. We take USDJPY as an example to walk through the analysis. Skew. a thicker left tail of the return distribution means that OTM put options have a higher probability of finishing in the money as compared to an OTM call with the same delta. the value of the put option increases even more than would be expected with a mere decrease in spot levels.5 12 11.” However. In this article. In fact there is well documented correlation between spot levels and the implied volatility levels. over time we would say there is no “risk premium.5 13 Implied Volatility 12. notice in fig. 1. The mechanism described above gives rise to the “skew” in the implied distribution. we conclude there is a “risk premium”. The delta of an option. Fig 1. if we see that the market consistently prices in a different correlation Fig 2. if volatility increases as the spot level falls.wherever there is correlation between implied volatility and spot we will see a skew. Additionally. the back end risk reversals tend to exhibit more overvaluation We also discuss applications of conditional variance swaps as a means of taking advantage of the “risk premium” • • Global Markets . The light distribution has a negative skew and the dark one is normally distributed • Introduction The famous Black Scholes model for option pricing has a questionable assumption of constant volatility of the return distribution. is computed under Black Scholes by assuming that the return distribution is normal.5 11 10. Even if the spot rate is kept constant. DB FX Research . The implied distribution is what the market expects and the realized distribution is what really happened.an intuitive explanation Skew means that the return distribution will be asymmetric and the left or the right tail is “heavier. The presence of a risk premium is usually accompanied by a trading opportunity. As an illustration of the concept. Implied Vol 13. This correlation which results in the well known smile or a smirk effect in options on various asset classes is also included in the new and more complex models of option pricing. In options markets. So naturally. Now imagine the case where on average the “expected” (risk neutral) correlation between implied volatility and spot levels implied by the distribution is on average similar to the correlation observed in reality. we propose a simple methodology to value risk reversals and propose trade ideas based on those valuations.” The absence of skew means that a distribution. will be symmetric with both tails having the same weight. which doesn’t hold up to empirical examination. for example the normal distribution. an increase in volatility makes an option more expensive since the price of a European or American style option always increases as volatility increases.

5 8 7. The implied volatility of the call option (mid market) is 7.1459x + 0. This shows that the market price of dollar puts with roughly the same probability of finishing in the money is higher than the price of dollar calls with the same probability of finishing in the money. a one month 25 delta risk-reversal would be long a one month 118. USDJPY implied volatility smirk means dollar puts/yen calls are more expensive USDJPY skew 9.09. Does USDJPY have a skew? When we examine the scatter plot of implied volatility and spot level we see that there is a negative correlation between spot level and implied volatility which is statistically significant. if the risk reversal is fairly valued with respect to realized volatility.34 strike USDJPY call and short a 114. In one instance (implied volatility) is how the portfolio would be marked to market and hence no systematic return would be made unless there was a correlation between the spot return and the implied volatility.43% vs.1756 10 15 1 m onth change in USDJPY Spot Source: Bloomberg. In other words. the put option volatility of 8. The difference between the implied volatilities of options with different strikes is called the volatility smirk or smile. if the portfolio was held to maturity then no systematic return would be made less there were a correlation with realized volatility. ATM volatility 7.6). these questions mean that if the market participant hedged out the contract such that only exposure to volatility remained then what kind of returns would their portfolios show. The explanation for the price difference between the calls and the puts follows directly from the explanation given above about the correlation between spot level and volatility.0. holding everything else constant. if the risk reversal is fairly valued with respect to implied volatility and the second. This results in the left tail of the returns being thicker as or a negative skew as explained above. DB FX Research 3 . Fig 3. It can also be thought about as expressing a dvega/dspot view which means a small change in the vega of the option portfolio given a small change in spot level. this leads us to the question if this is justified.77 strike USDJPY put. Essentially a risk reversal contract helps take positions on the spot–vol correlation in addition to a directional bet.Deutsche Bank@ between volatility and spot levels than is observed then there is a “skew risk premium” This skew risk premium is in addition to any “insurance premium” the writer of the put option might charge. In another instance. if the portfolio is delta hedged continuously then the trade only expresses a spot-vol correlation view.5 7 10P 25P DN Strik e s 25C 10C Source: Bloomberg. Naturally. DB FX Research Fig 4. What is a risk reversal? A risk reversal is a contract which is long 1 unit of a call option (typically 25 delta call option) and short 1 unit of a same delta put option (25 delta put option. There are two aspects to the question – first. implied volatility negative correlation continues in the present sample (Jan 2002-Sep 2006) 8 1 month change in 1m Implied Volatility 6 4 2 0 -15 -10 -5 -2 -4 -6 -8 0 5 y = -0.5 9 Im plied Volatility 8.0632 R2 = 0.1562x .03% (spot ref 117. USDJPY spot and implied volatility exhibit a negative correlation in the past sample (1997-2001) 8 1 month change in 1m Implied Volatility 6 4 2 0 -15 -10 -5 -2 -4 -6 -8 1 m onth change in USDJPY Spot 0 5 10 15 y = -0. Taking the example of USDJPY.0795 Fig 5. in the first instance we are testing an “implied skew” behavior and in the second we test the “realized skew” behavior. spot vs. Essentially.0509 R2 = 0. How can we see if USDJPY risk reversal is fairly valued? Naturally.

And then we calculate the value of the risk reversal with the following formula Value of risk reversal = βupmove* Out of moneyness of call .00 Jan. Fig 6.43%.Jan. we start with a broad assumption that a risk reversal is fairly valued if the implied volatility of a particular strike option remains constant.The 25 delta risk reversal in the front end is overvalued 4. this seems to be reasonable. and the at the money forward volatility increases to 8.00 1. DB FX Research Fig 7. then we consider the risk reversal to be fairly valued.00 -3. To compute the β coefficients we use the data for the last 3 months.spot up. The 10 delta risk reversal is overvalued with respect to implied volatility Source: Bloomberg.03% from 7.Nov. Naturally.Oct. that this coefficient will also be negative since a spot sell off usually results in an implied volatility rally.Aug.00 -4.Jul.34 if the at the money volatility goes to 7.moves and spot down-moves. in case of USDJPY this coefficient is negative since as spot rallies the implied volatility usually sells off.Nov.00 -7. However.Sep.09 to 114. For example through a large part of 2004 the front end risk reversals were overvalued with respect to implied volatility.βdownmove *Out of moneyness of put our model captures the various movements in the price of the risk reversal.Apr. given that we look at the “local” changes in spot every day and the related changes in implied volatility accompanying it.Dec. We perform a regression to get the coefficient βupmove which tells us how much implied volatility moves per unit of spot movement up. We tried different time windows for computing the β coefficients and found that the 3 month gave the best results (as measured by the least amount of squared pricing errors).Is the risk reversal fairly valued with respect to implied volatility? (USDJPY as an example) To answer this question. There are times when the model value and the market value of the risk reversal diverge and those might be trading opportunities.00 2.77. DB FX Research We look at data from January 2000 to August 2006 and find that the risk reversal seems reasonably correctly valued. . As can be seen from fig 6. which is a true test of how good this simple model is.00 -2. Any trading strategy based on that would take advantage of this model valuation to generate positive returns. say the USDJPY spot level falls from 117.Feb.00 3. Note. We record the data sample of spot and implied volatility moves into two samples . We take the up-moves sample and measure the change in spot and the related changes in the implied volatility.M ar.Jun.M ay.00 -6.00 -1.Apr00 00 00 01 01 02 02 02 03 03 04 04 05 05 05 06 25 del M odel Value 25 del P rice Source: Bloomberg. when spot rallies to 118. We perform a similar analysis on the down move sample and get the βdownmove which is the coefficient of the change in implied volatility when spot sells off. Continuing with the example above. We then compute how far out of the money the call and the put options are (125 pips for the USDJPY call and 232 pips for the USDJPY put in the above example).Jun.6% and similarly.00 -5. Naturally this is a rather simple assumption (also known as sticky by strike).

in the earlier case.0252x + 0. If the returns were indeed normally distributed. 8 show that the realized skew is always higher than the implied skew or that in this small sample. And naturally the realized risk reversal has a higher value than the implied USDJPY Realized vs.00 1. In other words is the realized skew equal to the implied skew of the distribution. Fig 8. we evaluated the question of if spot moved instantaneously and one were to sell the portfolio (having hedged all other risks but volatility risk) then would the return on the portfolio be positive. Notice. Now we examine if the realized volatility shows any correlation with the spot levels.00 -1.e." Why does being long USD calls / short USD puts in USDJPY produce a positive return? Implied volatility has a risk premium built in it in addition to the future expected realized volatility. then the skew should be zero.3364x + 0.n (25)/At The Money Volatilityt.00 -4.Deutsche Bank@ Is the risk reversal fairly valued with respect to realized volatility? Now we try to answer the question of does the portfolio of long one unit 25 delta call and short one unit 25 delta put pay off if held to maturity. is the volatility risk premium merely a convenience cost (i. However. For this we use some of the well known results in financial literature from Breeden and Litzenberger (1978) to infer the risk neutral distribution of the returns from the option prices. A deeper question remains.e.n Here t is the time to maturity and n the evaluation time. DB FX Research Fig 9.4478* RiskReversalt.is the risk premium justified? I. the strategy that systematically sells dollar puts provides insurance against the possibility of a big sell off in spot.n = 4.00 -3.00 -2.0106 R2 = 0. Then we take the actual log returns of the USDJPY spot and compute the skew of that distribution. Essentially.0625 R2 = 0. since 2002 this relationship has broken down 8 6 1 month change in 1m Realized Volatility 4 2 0 -15 -10 -5 -2 -4 -6 -8 1 m onth change in m e an USDJPY Spot 0 5 10 15 y = 0. Source: Bloomberg.0488 4 2 0 -15 -10 -5 -2 -4 -6 -8 1 m onth change in m e an USDJPY Spot 0 5 10 15 Source: Bloomberg. The results in fig. DB FX Research Fig 10. In the earlier case the only volatility one cared about was the implied volatility since we assume that only a very small interval of time passes before the portfolio is revalued and hence the exposure to realized volatility is minimal. In other words selling dollar puts and buying dollar calls produces positive returns for the market maker when the investor buys “insurance. DB FX Research 5 . the portfolio produces positive returns.00 0. The formula derived for the relationship between the implied skew and the risk reversal is as follows: Skewt. Realized volatility and spot had a similar negative relationship from 1997-2001 8 6 1 month change in 1m Realized Volatility y = -0.0006 This formula enables us to compute the risk neutral implied skew from the risk reversal prices. The time period of the data (Apr 03 – July06) is a “small sample” in that there is no event when the yen appreciated with a shock. Implied Risk reversal 2.00 M ar-99 M ar-00 M ar-01 M ar-02 M ar-03 M ar-04 M ar-05 S ep-99 S ep-00 S ep-01 S ep-02 S ep-03 S ep-04 S ep-05 M ar-06 S ep-06 Realized Riskie Implied Risk Reversal Source: Bloomberg.in other words the distribution should be symmetric and there should be no correlation between spot level and volatility.

25% in 1 year maturity Mathematically the pay off can be expressed as: 2    Si  1 N   Payoff = ∑1Si−1 < H 252 log S  − σ 2    N − 1 i =1 i −1       Here if i-1’th spot fixing is below the level H then 1Si−1 < H = 0 and if it is above then = 1 How do the suggested trades take advantage of the “risk premium?” The short conditional variance swap leg enables selling the realized volatility when spot sells off. we are confident of low realized volatility in the near future. carry trade unwinds and bouts of risk aversion are all correlated. Now structures like the conditional variance swap utilize the spot and volatility correlation to improve the volatility break even and the contract is structured as follows: • • • If spot remains above 114 the variance swap works in the usual way If spot moves below 114. A simple variance swap pay off is just the difference between the implied and realized variance. it is willing to pay a higher “insurance premium” for the same risk. The BoJ’s stance on interest rates also helps us determine the feasibility of the trade. As the BoJ looks unlikely to raise rates soon.85% to 8. which is usually lower than the market implied volatility and has little relation to spot level. Any increase in the “uncertainty” or increase in risk premium as spot sells off or due to some macro economic event will also favor this trade since typically higher the risk aversion. In a low volatility environment a conditional variance swap is an ideal way to leverage a core view that volatility will pick up over the coming months. 2 2 Payoff = σ Realised − σ Strike positive returns. when the market is more risk averse.6 vols from 8. the conditional variance swap collects the risk premium when spot sells off. How can we use variance swaps to take advantage of the “risk premium?” The data makes us think that a smart way to trade yen volatility would be to be long only implied volatility and skew and sell the realized volatility and skew. However. Not unnaturally. the higher the premium we collect and hence the better the strike improvement. Naturally. fixings below 114 do not contribute to the variance calculation Strike improvement of 0. which is results in . An interesting insight is that yen rallies.What is the real macroeconomic risk? – an example could be a global recession risk due to a US current account deficit. the central question remains. Essentially. the carry trade is back.the amount of money you pay to not have to synthetically manage your portfolio to create a call option) or is there a covariance with a risk factor involved. In the rest of this piece we examine risk reversal value for other G10 currency pairs.

0355 Source: Bloomberg.2380 and 1. Since then it has traded sideways and is in what we classify as the third regime. Unless.Sep00 00 00 01 01 02 02 02 03 03 04 04 05 05 05 06 06 Source: Bloomberg. So our view is that the front end risk reversals are somewhat overvalued. When the risk reversal price produced by the model consistently provides a value above the current price.9 0.”. in the middle of 2002 the risk reversals were cheap with respect to implied volatility.Nov. implied volatility rallied 5 1 month change in 1m Implied Volatility 4 3 2 1 0 -0.Apr.00 -6. we would prefer to be a seller rather than a buyer at those levels. DB FX Research Fig 12. during which the risk reversal changed from favoring EUR downside to EUR upside and in the second regime EURUSD moves up meant an increase in implied volatility.Mar.Oct.2 vols for EUR puts are slightly expensive. The other general finding is that risk reversals rarely pay for themselves if they are higher than 0.00 25 del Model Value 25 del Price Jan. Looking at EURUSD spot we see three main regimes. at the moment EURUSD 1m risk reversals are cheap.5 vols.Deutsche Bank@ EURUSD At the moment. Front End EURUSD risk reversals are slightly overvalued with respect to implied volatility 6. When we have sharp and persistent divergences from the model in the front or the back end it implies a trading opportunity.Sep.20 y = -9. We observe that risk reversals tend to trend with spot values.00 4.2380 and to sell off if spot retraces back to 1. DB FX Research 7 .00 -8.1 1 0. we believe that the market is overestimating the possibility of a “regime shift” once more after a sharp spot move.Apr. We expect the implied to rally if spot goes to 1.00 -4.3 1.8 and 6.55 respectively.0.Nov. Fig 11. our model says that the EURUSD front end risk reversals which just switched sign from being positive to negative at -0.00 -1 -2 -3 -4 -5 1 m onth change in EURUSD Spot 0.35 vols is also somewhat over priced with respect to implied volatility although it has been tending towards fair value.5 1. we expect a big macro shock. In the third regime of EURUSD trading sideways we see that EURUSD risk reversals are fairly valued and spot increases still mean implied volatility increases.6956x .10 0.Jul. From 1999-2002 EUR puts were better bid and if spot fell.2720 for vols of 6.Jun. The 1m 25 delta strikes are 1.8 Jul-99 Jul-00 Jul-01 Jul-02 Jul-03 Jul-04 Jul-05 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jul-06 Source: Bloomberg. There was a regime change in 2002. EURUSD spot “regime” change in 2002 led to EUR calls being more expensive EURUSD spot rate 1. Our analysis of risk reversal with respect to realized volatility indicates that it is overvalued.Aug.Dec. The back end (=1 year) risk reversal at 0.20 -0. However.4 1.May.10 0. Before 2002 EURUSD was in a downward trend and after 2002 it was in an uptrend that lasted until 2005. In the first EUR bearish regime any spot moves lower meant an increase in implied volatility.Jan.Jun. Historically.2720 and be lower.0497 R2 = 0. That pattern continued through that year and gradually they returned to fair value in 2003.Feb.For example. DB FX Research Fig 13.00 2.00 -2. it means that the risk reversals are “cheap.2 1.

Interestingly we notice the pattern that the front end risk reversal is close to fair value in these situations. This indicates to us that the market might have been overpricing the risk reversals in that period. They had been bid for sterling calls since 2001 when spot started trending higher. We agree that any GBPUSD rally is more likely to result in spot being back in the “range” which is bearish volatility.20 -0. based on the risk reversal model is to examine periods when the model valuation is significantly and persistently different from the actual valuation. as would have selling them (sell GBP calls / buy GBP puts) in November and December 2003. DB FX Research .0. The simplest way to formulate a trading strategy. we like buying and if the model values are lower than the current risk reversal values. that the realized volatility and spot levels display no significant relationship during the current sample period of 1999-2005. with the 1 month risk reversal at -0. perhaps because people are unwilling to buy vanilla options when they see realized volatility being low and the expected realized volatility in the near future is low as well.00 -2 0. the back end risk reversals which were priced at 0.10 0. When spot is in a trending cycle then risk reversals tend to be have higher values. if the model values are higher than the risk reversal values.15 -0. DB FX Research Fig. GBPUSD traded sideways and then mostly downward from 1996 to 2002. or attaching a large risk premium to a large dollar move downward. In times of sideways movement risk reversals tend to be reasonably correctly valued. 15. GBPUSD realized volatility has shown no correlation to realized spot movements 6 y = -3. we like selling.20 Source: Bloomberg. Notice. However. implied volatility still rallied when spot moved up. for this currency pair also we find that when the risk reversals price gets to more than 0.2250 they have come closer to being fairly valued. However. notice that the back end of the risk reversal is still slightly overvalued according to the model. However. Additionally. This probably reflects a term structure of risk premium which is upward sloping or liquidity and hedging costs. At the moment. which may be ascribed to overvaluation or possibly a higher risk premium on a spot move up.05 0.0022 1 month change in 1m Realized Volatility 4 2 -0.30 vols seemed overvalued with respect to implied volatility. Although.10 0.00 -2 -3 -4 -5 1 m onth change in GBPUSD Spot 0.0496 R2 = 0. For example in GBPUSD. Until recently.10 -0.5 vols they rarely tend to pay for themselves. Fig. Naturally. with the recent move down to 0. GBPUSD implied volatility has rallied with spot rallies. With little speculative interest and little realized volatility the price of the risk reversal decreases.8963x .3271x + 0. Historically. however according to our model the odds are higher that the dollar up move is subdued than is currently implied by the distribution.18 favoring downside. This led to the realized skew being quite low and hence the realized risk reversal was overvalued for most of the 1999-2005 period. 14.0353 R2 = 0. At the moment we prefer to sell the USD calls and buy USD puts and then wait to buy them back for a small profit when the market prices in a lower chance of a spot break and the risk reversal price comes down.10 -10. we note that in Sep 2002 buying risk reversals (buy GBP calls / sell GBP puts) would have generated substantial positive returns.GBPUSD GBP risk reversals have just flipped direction from being bid for sterling calls to being bid for sterling puts.15 -4 -6 1 m onth change in m e an GBPUSD Spot Source: Bloomberg.0927 4 3 2 1 0 -0. The implied vol and spot correlation have a positive relationship 5 1 month change in 1m Implied Volatility y = 5.05 0 0. we think that the market has overreacted with respect to the dollar rally and the probability of a sharp dollar up move is less than implied by the risk reversal. however realized volatility rarely tends to follow.

00 0. between 0.50 -0.Deutsche Bank@ NZDUSD With the exception of USDJPY and the yen crosses. these carry trades are unwound dramatically and the currency lurches lower.Mar98 98 99 99 00 00 01 02 02 03 03 04 05 05 06 Realized Riskie Implied Risk Reversal Source: Bloomberg. NZDUSD exhibits the most extreme risk reversals in the G10 FX world. This overvaluation becomes most apparent after the early 2004 drawdown of 2003 carry trade (NZDUSD up 30% in ’03).Oct.Feb. as seen in fig.00 0. the realized skew of the NZDUSD distribution is a lot less negative in our sample than implied by the value of the risk reversal.50 Jan. Since mid 2004.50 -1.Jul. 17.50 -1.00 -1. Risk reversals rarely pay for themselves if they exceed 0. Realized skew is not as negative as implied skew.Apr. as we shift to longer dated risk reversals. With 1 year rates above 7.50 Jan00 Jul00 Jan01 Jul01 Jan02 Jul02 Jan03 Jul03 Jan04 Jul04 Jan05 Jul05 Jan06 Jul06 Source: Bloomberg. rises in US rates have reduced the interest rate differential and removed the attraction of USD of a funding currency thus reducing the interest in the NZDUSD carry trade. The NZDUSD realized skew exceeded the implied skew for a brief period when the NZD fell sharply but it seems the longer dated risk reversals priced in a “regime change” of falling spot and hence they have not been worth it subsequently as they have remained around 0. Back End NZDUSD risk reversals are overvalued with respect to implied volatility 1.00 1.00 25 del Model Value 25 del Price Jan00 Jul00 Jan01 Jul01 Jan02 Jul02 Jan03 Jul03 Jan04 Jul04 Jan05 Jul05 Jan06 Jul06 Source: Bloomberg.Dec.50 -3.5%.75 vols since 2004. Additionally. Fig 16. We find that in our model.50 0.00 25 del Model Value 25 del Price 0. long kiwi dollar positions are naturally very popular with FX carry traders.50 -2. However.Sep.50 1. During bouts of risk aversion. This suggests the back-end Kiwi risk reversals are overvalued both in terms of implied and realized volatility moves. causing higher actual volatility and higher implied volatility as traders scramble to buy gamma to cover their positions.00 1.5 vols 2.May.00 -1.00 -2.50 -2.Jun.Aug.Nov.00 -1.50 - -0. The market preference for puts on the kiwi dollar is due to the currency’s position as the highest yielder in the G10.00 -0. front end risk reversals are undervalued with respect to moves in implied volatility. DB FX Research Fig 17.50 -1.Mar. DB FX Research Fig 18.50 1.Jan.00 -2. we find that the market overestimates the change in implied volatility when spot changes. DB FX Research 9 .50 2. NZDUSD front end risk reversal is undervalued with respect to implied volatility 2.5 and 1 vol favoring kiwi puts.Aug.

00 4.00 -1.00 -3.0784 R2 = 0. At these levels both the front end and back end risk reversals seem overvalued with respect to implied volatility. We find that while there is a significant negative relationship between implied volatility and spot levels.00 3. There was a big sell off in GBPJPY spot in the year 2000 when GBPJPY went from around 179 to 148.Jul00 00 Jan.0.00 -3.00 0. This dynamic leads us to suggest conditional variance swaps or premium collecting trades for this currency pair. DB FX Research Fig 21. GBPJPY realized volatility shows no relationship with spot moves in our sample 6 1 month change in 1m Realized Volatility 4 2 0 -5.Jan. Implied Risk rev ersal 5.00 4. this results in the skew implied by the distribution having a much more negative value than the actual skew in the realized distribution.Jul02 02 03 03 04 04 Jan. 21). Fig 20. The 1m risk reversal is priced at -0. DB FX Research Fig 22.Jul.00 2. GBPJPY risk reversals are bid for downside with investors demanding protection for long cash positions.00 -1.00 3. fig.00 1.00 y = -0.Jan. Also.00 -4.00 2.00 3.00 1. Back End GBPJPY risk reversals are over valued with respect to implied volatility 8. spot trends have definitely driven the risk reversal prices in this currency pair as well. GBPJPY realized risk reversal has usually exhibited a less negative skew than implied Re alized vs.00 Jan.today.00 -2.GBPJPY Like any other carry trades.00 -2. there is no significant relationship between the spot moves and the changes in the realized volatility (from 2002.00 -1. Like other currency pairs analyzed before.00 -2 -4 -6 1 m onth change in m e an GBPJPY Spot 1.00 7.Jul.0053 Source: Bloomberg.Jul01 01 Jan.00 -3. the risk reversal more than pays for itself and after that the “risk premiums” turn more negative and the risk reversal becomes overvalued. We think that these sharp “crashes” might cause a market “crash” risk premium.00 6. Naturally. on average the risk reversal rarely pays for itself in GBPJPY.Jan. For a certain amount of time.Jul.0528x .00 F eb-99 F eb-00 F eb-01 F eb-02 F eb-03 A u g -9 9 A u g -0 0 A u g -0 1 A u g -0 2 Realized Riskie Implied Risk Reversal F eb-04 F eb-05 A u g -0 3 A u g -0 4 A u g -0 5 F eb-06 Source: Bloomberg.Jul05 05 06 06 25 del Model Value 25 del Price Source: Bloomberg. DB FX Research A u g -0 6 .00 5.6 vols and the one year is 0.00 -5.72 and since then there have been several small sharp sell offs.72 vols.00 5.

DB FX Research Source: Bloomberg.00 -1.Jan.00 -3.00 -1 -2 -2 1 m onth change in AUDJPY Spot 1.Jul.99.Jan.00 1.Jul00 00 01 01 02 02 03 03 04 04 05 05 06 06 Source: Bloomberg.00 M ar-99 M ar-00 M ar-01 M ar-02 M ar-03 M ar-04 M ar-05 Sep-99 Sep-00 Sep-01 Sep-02 Sep-03 Sep-04 Sep-05 M ar-06 Sep-06 Fig 25.Jul00 00 01 01 02 02 03 03 04 04 05 05 06 06 Source: Bloomberg.5 vols.4%) and the low Japanese interest rates (0.Jan. AUDJPY went from around 71 to 55. We like buying 6 month AUDJPY variance swaps at 7.0234 R2 = 0.Deutsche Bank@ AUDJPY AUDJPY has consistently been one of the most popular carry pairs due to the high Australian interest rates (6. It is also a reasonable argument that this implied skew includes a “crash premium. DB FX Research 11 .00 -2.” At these levels the front end risk reversals are fairly valued with respect to implied volatility but the back end risk reversals are overvalued with respect to the implied volatility.66%).00 -5.8% while the regular var swap is at 8.Jul.00 2.00 -1.Jul.Jul.Jul.00 3. DB FX Research Fig. When we glance at the charts we notice that AUDJPY follows the typical yen cross sell off patternsell off happens. AUDJPY realized skew is consistently less negative than the implied skew Realize d vs.15%.00 -2.00 2. this pair exhibits a significant skew. for example in 2000.Jul.95 vols and the one year is -1.00 y = -0.Jul.00 25 del Model V alue 25 del Price Realized Riskie Implied Risk Reversal Jan. Implied Risk reversal 3.Jul.Jul.00 -2. Front end AUDJPY risk reversals seem fairly valued with respect to implied volatility 3.1 month 25 risk reversal is valued at -0.00 1.Jul. 26.1622 2.00 -2.Jan.Jan.Jul.00 -3.00 Source: Bloomberg. This means that the risk reversal is overvalued with respect to realized volatility.00 -3.Jan.00 2.Jan.00 0 -10.00 -5.00 1. DB FX Research Fig 24.Jan.2357x + 0.Jul.Jan. In this case the fixings below 87 will not count towards the var swap calculation.Jan. Naturally.00 25 del Model V alue 25 del Price Jan. the realized skew of the return distribution is consistently less negative or less on an absolute value basis than is implied by the value of the risk reversal contract.00 -1.00 0. AUDJPY has a negative relationship between spot and implied volatility 2 2 1 month change in 1m Implied Volatility 1 1 -3. short and long end implied risk reversals widen considerably.00 -4. With a history of frequent and sharp sell offs. for a short period of time front end risk reversal pays for itself and then gradually it becomes more expensive.00 -1.00 -4.Jan. Back End AUDJPY risk reversal has been consistently overvalued according to the model 3.Jan. while the back end risk reversal frequently doesn’t pay for itself (esp. if kept to maturity). Fig 23. As expected.

00 1. AUDUSD back end risk reversals seem over valued with respect to implied volatility 0.40 -0.00 -1 -2 -3 1 m onth change in AUDUSD Spot y = -6. Again.60 -0.00 -1.5 vol and the back end is -0. DB FX Research Fig 28.05 0. The spot trend and risk reversal pricing dynamics work similar to other currency pairs.20 -1. Implied Risk re ve rsal 4. we notice that the implied distribution seems to overestimate the skew present in the realized return distribution.20 -0.00 -1. Also.20 -0.50 -1.7021x .017 -0.00 25 del Model Value 25 del Price Jan00 Jul00 Jan01 Jul01 Jan02 Jul02 Jan03 Jul03 Jan04 Jul04 Jan05 Jul05 Jan06 Jul06 Source: Bloomberg. AUDUSD realized risk reversal has been consistently less negatively skewed than the implied Realize d vs.00 0.40 Jan00 Jul00 Jan01 Jul01 Jan02 Jul02 Jan03 Jul03 Jan04 Jul04 Jan05 Jul05 Jan06 Jul06 Source: Bloomberg. AUDUSD spot and implied volatility have a slightly negative correlation 3 1 month change in 1m Implied Volatility 2 1 0 0. The risk reversal is overvalued with respect to realized volatility (fig 30) so we like collecting the risk premium via instruments like conditional variance swaps.00 -2.10 Source: Bloomberg. DB FX Research . At these levels the front end risk reversals are fairly valued with respect to implied volatility while the longer dated risk reversal contracts seem overvalued with respect to implied volatility.00 F e b -9 8 F e b -9 9 F e b -0 0 F e b -0 1 F e b -0 2 F e b -0 3 F e b -0 4 F e b -0 5 A u g -9 8 A u g -9 9 A u g -0 0 A u g -0 1 A u g -0 2 A u g -0 3 A u g -0 4 A u g -0 5 F e b -0 6 A u g -0 6 Fig 29. 30.00 -2.50 -2. DB FX Research Source: Bloomberg.50 -3.57 vols.00 2.10 -0.50 1. in keeping with the big spot move leading to risk reversal overvaluation.AUDUSD AUDUSD 1m risk reversal is -0.00 -1.60 0. Fig 27. we observe that the back end risk reversal became “overvalued” with respect to implied volatility after we saw a massive sell off in AUDUSD spot in end of 2003 to the middle of 2004. We find that as AUDUSD rallied steadily from 0.80 from 2002 to 2003 risk reversals went bid for AUD calls.00 0.40 25 del Model Value 25 del Price Realized Riskie Implied Risk Reversal 0.63 to 0. reflecting a spot regime change.00 1.50 2. We see that spot and implied volatility have a slight negative correlation.0123 R2 = 0.00 3. AUDUSD front end risk reversals seem fairly valued with respect to implied volatility 2.05 0.0.50 -0. DB FX Research Fig.80 -1.

DB FX Research Fig 34.50 - -0.00 -1.0068 R2 = 0.05 0.50 0.10 -0. Essentially the idea of the market “over reaction” seems to be prevalent. Implied Risk reve rsal 1.50 1.60 0.00 -1 -2 -3 1 m onth change in USDCAD Spot y = -2. USDCAD front end risk reversals are faily valued with respect to implied volatility 1.Deutsche Bank@ USDCAD USDCAD 1m risk reversal at 0. For example if USDCAD rallies and breaks the range then the risk reversal is bid for USD calls and if USDCAD sells off and breaks the range then CAD calls are more expensive. when spot breaks out of range then the risk reversal contracts become bid in that direction.50 -1.80 0.50 Jan00 Jul00 Jan01 Jul01 Jan02 Jul02 Jan03 Jul03 Jan04 Jul04 Jan05 Jul05 Jan06 A ug -06 Jul06 Source: Bloomberg. for a short period of time the risk reversals do pay for themselves as – for example in May 2002 the risk reversals more than paid for themselves. USDCAD implied and realized skew are usually close to each other and fairly valued Realized v s. USDCAD spot and implied volatility have a slightly negative correlation which is not very stable 3 1 month change in 1m Implied Volatility 2 1 0 0.50 25 del Model V alue 25 del Price 1. Like other currency pairs in USDCAD risk reversal also.00 0. However.10 -0. we find that it is easier to sell into the rallies by using the model carefully to find a persistent overvaluation the market. in June 2003 the risk reversals were overvalued in 2003 as USDCAD had a sharp decline and the risk reversal went bid for CAD puts. USDCAD back end risk reversals are fairly valued at the moment 0. DB FX Research Source: Bloomberg.20 25 del Model Value 25 del Price -0.20 -0.00 -0. However. we observe that whenever spot is trading within a range the front end risk reversals are usually fairly priced.07 vol is fairly valued with respect to implied and realized volatility. DB FX Research Fig 32.00 0. Fig 31.1 vol and 1y at 0.00 Jan00 Jul00 Jan01 Jul01 Jan02 Jul02 Jan03 Jul03 Jan04 Jul04 Jan05 Jul05 Jul06 Source: Bloomberg.00 -1. The spot and implied volatility have a slight negative correlation which is not very stable through time which means that the risk reversals flip signs from positive to negative frequently. DB FX Research 13 . However.50 -1.40 -0.40 0.05 0.50 F e b-9 8 F e b-9 9 F e b-0 0 F e b-0 1 F e b-0 2 F e b-0 3 F e b-0 4 F e b-0 5 A ug -98 A ug -99 A ug -00 A ug -01 A ug -02 A ug -03 A ug -04 A ug -05 F e b-0 6 Jan06 Realized Riskie Implied Risk Reversal Source: Bloomberg. This “overvaluation” seems to result from an overestimation of the probability of the sharp spot move continuing.60 -0.80 -1.8797x + 0.0127 Fig 33.In general.

we see that EURCHF spot shows the classic sharp sell off and slower rallies up. longer dated CHF calls might be seen as providing insurance.00 25 del Model Value 25 del Price 0.50 -1.01 0. the back end risk reversal at -0.00 -1.50 -2.00 0.00 -1.50 -2. EURCHF back end risk reversal is over valued according to the model 1.00 J a n-9 9 J a n-0 0 J a n-0 1 J a n-0 2 J a n-0 3 J a n-0 4 J a n-0 5 J a n-0 6 J u l-9 9 J u l-0 0 J u l-0 1 J u l-0 2 J u l-0 3 J u l-0 4 J u l-0 5 J u l-0 6 Realized Riskie Implied Risk Reversal Source: Bloomberg.EURCHF EURCHF implied volatility and spot show a slight negative correlation and the 1m risk reversals are priced at -0.00 Jan00 Jul00 Jan01 Jul01 Jan02 Jul02 Jan03 Jul03 Jan04 Jul04 Jan05 Jul05 Jan06 Jul06 Source: Bloomberg.50 -3. which like the previous currency pairs.00 -2.01 -1 -1 -2 -2 1 m onth change in EURCHF Spot 0. Implied Risk reve rsal 2. 35). DB FX Research Fig 36. Fig 35. EURCHF implied volatility and spot show a slight negative correlation 2 1 month change in 1m Implied Volatility 2 1 1 0 -0.0 y = -7. DB FX Research Source: Bloomberg.0314 Fig 37.03 0.50 -0.00 0. At this level the front end risk reversals are fairly valued with respect to implied volatility (fig.05 -0. since in CHF crosses there is the belief of CHF being a crisis currency. Again.50 -2.0.05 vols which means that they are almost “flat” (i. The flat level implies that the spot has not had a massive trend so it is not a surprise that it is “fair value.50 -1.00 -0. call and put have almost similar implied volatilities).01 R2 = 0.50 0. EURCHF realized skew is consistently less negative than the implied skew Realized v s.50 - -0.e. means that the implied skew is likely to be more negative and the longer term risk reversals are more likely to be “overvalued” Additionally.03 -0. DB FX Research .00 -1.50 -1. EURCHF front end risk reversals are fairly valued at the moment 1.50 1.1506x .00 1.” However.00 25 del Model Value 25 del Price Jan00 Jul00 Jan01 Jul01 Jan02 Jul02 Jan03 Jul03 Jan04 Jul04 Jan05 Jul05 Jan06 Jul06 Source: Bloomberg.125 vol is slightly overvalued (fig 37) and the actual skew is consistently less on an absolute value basis than what is implied by the distribution derived from the risk reversal contract. DB FX Research Fig 38.

Implied Risk reversal 5.00 -5.50 25 del Model V alue 25 del Price Jan00 Jul00 Jan01 Jul01 Jan02 Jul02 Jan03 Jul03 Jan04 Jul04 Jan05 Jul05 Jan06 Jul06 Source: Bloomberg.00 -2. DB FX Research 15 . After the sharp down move it is also interesting how even in the front end risk reversal the implied and realized skew diverge due to the addition of the “risk premium”. EURJPY has experienced a steady uptrend and occasional sharp draw-downs.0125 R2 = 0.00 -3.00 2. the back end risk reversal is overvalued and we notice that the skewness implied by the distribution is more (on an absolute value basis) than what is realized in actual returns.00 25 del Model Value 25 del Price Jan00 Jul00 Jan01 Jul01 Jan02 Jul02 Jan03 Jul03 Jan04 Jul04 Jan05 Jul05 Jan06 Jul06 Source: Bloomberg.00 1.0954 1.00 2.00 Source: Bloomberg. essentially there is a stable negative relationship between spot and implied volatility.today 2.50 -1. Since then. EURJPY has exhibited negative correlation of spot and implied volatility from 2002. Similarly. In 2003 EURJPY experienced sharp down moves and naturally the back end risk reversal in EURJPY suddenly became overvalued after 2003 due to the “insurance premium” attached to the possibility of another sharp down move.00 -2.5 1 month change in 1m Implied Volatility 1.0 0. In our opinion it is these drawdowns that provide a good trading opportunity. The implied and realized skew become less negative in the end of 2000 and beginning of 2001 as EURJPY rallied sharply resulting in the implied and realized skew changing across all models.50 -0.0 -0. DB FX Research Fig 39. The front end risk reversal is overvalued (fig.00 -1. DB FX Research Source: Bloomberg. 39) with respect to implied volatility.00 -4.5 -2.00 1. EURJPY realized skew has been consistently less negative than implied by the risk reversals Realized vs.00 -1.0. These are reflected by our model .0 1 m onth change in EURJPY Spot y = -0. EURJPY front end risk reversal is overvalued according to the model 3.50.00 -1.00 J ul-99 J ul-00 J ul-01 J ul-02 J ul-03 J ul-04 J ul-05 J an-99 J an-00 J an-01 J an-02 J an-03 J an-04 J an-05 J an-06 J ul-06 Realized Riskie Implied Risk Reversal Fig 40.00 -3.00 3.50 -2.00 -1.Deutsche Bank@ EURJPY EURJPY has similar characteristics to USDJPY and other yen crosses.0 -1. Fig 38.00 -1.00 0. Back end EURJPY risk reversal has been consistently overvalued wrt implied volatility 1.111x .00 0.5 -2. DB FX Research Fig 41.we see that the model line is consistently closer to zero as compared to the actual price of the risk reversal almost through the life of the model (refer to chart).0 1. either via buying the risk reversal or via conditional variance swaps.

Jul.00 1. DB FX Research .Jan.05 0. DB FX Research Fig 45.Jul00 00 01 01 02 02 03 03 04 04 05 05 06 06 Source: Bloomberg.Jan.1076 R2 = 0. this risk reversal also seems fairly valued with respect to realized volatility.00 -4.23 for CHF puts which is much closer to fair value with respect to implied volatility (fig 44).00 -3.Jul.00 25 del Model V alue 25 del Price Jan00 Jul00 Jan.00 25 del Model V alue 25 del Price Realized Riskie Implied Risk Reversal 0.Jul01 01 Jan02 Jul02 Jan03 Jul03 Jan. We agree with the logic presented.00 0.00 2.00 2.Jan. Implied Risk reversal 3.00 -1. The 1m (front end) risk reversal is bid 0. this is a function of the market reasoning that there will be a sharp dollar up move and as spot breaks out of range the volatility will go bid.00 -1 -2 -3 1 m onth change in USDCAD Spot y = -11.There is a possible argument that they might have a risk premium built in and hence might seem more “overvalued. DB FX Research Fig 43.2375 -0.00 1.” With the implied and realized skew of the front end risk reversal close to zero .Jul.00 Jan. DB FX Research Source: Bloomberg.50 -1.10 Source: Bloomberg. Our preferred trade in USDCHF would be to buy the back end risk reversal in times of a crisis and collect the crisis premium.Jul.Jan.50 -2.Jul.USDCHF As a “safe haven” currency CHF. Usually.Jul.10 -0.00 3. USDCHF front end risk reversal is overvalued valued according to the model 4. typically rallies in times of crisis.00 -2. realized skew.00 -3. However when we examine the back end for implied vs. USDCHF realized skew is close to the skew implied from the risk reversals Realized vs. but disagree with the probability of the sharp dollar move.05 0. The back end risk reversals have come in over the last two weeks from -0. We think that the probability of the sharp dollar move up is considerably less than implied by the risk reversal distribution. Thus we find that USDCHF spot and implied volatility have a stable negative correlation.Jul04 04 Jan05 Jul05 Jan06 Jul06 Source: Bloomberg.45 vols (bid for CHF puts) to -0.Jan. we find that the risk reversal is overvalued with respect to realized volatility. 43) Once again. USDCHF spot and implied volatility have a stable negative correlation 3 1 m onth change in 1m Im plied Volatility 2 1 0 0.00 -2.0.30 for USD calls and we think they are overvalued (fig.00 -1.00 -1.00 F eb-98 F eb-99 F eb-00 F eb-01 F eb-02 F eb-03 F eb-04 F eb-05 A ug-98 A ug-99 A ug-00 A ug-01 A ug-02 A ug-03 A ug-04 A ug-05 F eb-06 A ug-06 Fig 44.50 - -0. in times of crisis implied volatility shoots up also.Jan. Fig 42.684x . USDCHF back end risk reversal is slightly overvalued 1.

” However. We think a similar explanation of the “crash risk premium” drives the difference in the realized and implied skew. A good (but rough) rule of thumb is that risk reversals rarely pay for themselves when they are above 0. Below we discuss and summarize the observations of valuations with respect to implied and realized volatility and also note possible improvements to the model. In the event of a sharp spot movement the realized skew exceeds the implied skew for a certain period of time and the risk reversal “pays for itself. These result in the most systematic trading opportunities of selling the overvalued risk reversal. the investors attach a higher subjective probability of a sell off happening again. The back end risk reversals seem to have a higher tendency to become “overvalued” with respect to implied volatility and remain that way for longer periods. we still need to uncover the “macroeconomic” or consumption based asset price factor that underpins the purported risk premium.” So after the carry currency pair experiences a sharp sell off. That seems impractical at this stage. However. • • • • Further improvements to the model With our model. The effect of a sharp spot movement on back end risk reversals is greater. However. There is no theoretical reason at all for the spot and volatility relationship to be linear. many market participants are invested in the carry trade.Deutsche Bank@ Analysis of the risk reversal model We observe a few systematic patterns from our skew valuation models. Additionally. which would then be calibrated to fit the various market observed option prices and end up as a time varying mix of local and stochastic volatility model and we would simulate the path taken by spot and then estimate the returns of our investment strategies to really capture the risk reversal value with respect to both implied and realized volatility. we are inherently subscribing to some sort of a linear relationship between spot and volatility which is closer to a Heston type stochastic volatility model (although we allow for the correlation to vary across time) than a local volatility model. At that point we find the front end risk reversal contract becoming overvalued with respect to implied volatility. the back end overvaluation could also reflect a term structure of “risk premium” which is upward sloping. A sharp spot movement usually results in the front end risk reversal paying for itself for some time but then the market begins to “overestimate” the volatility changes with respect to spot movement.5 vols. These currency pairs experience sharp declines and hence these investors bid up the prices of the lower interest rate currency calls as they all want to buy “protection. front end risk reversals tend to be close to fair value with respect to implied volatility as the market seems quite good at pricing the risk reversal with respect to implied volatility during those times. We observe that the difference between the realized and implied skew is more substantial in the higher carry currencies. We don’t observe many systematic trading opportunities. All this will naturally require considerable calibration and computation. Usually. To be theoretically more correct we should have a volatility and spot relation model for every currency pair. We find the overvaluation effects to be exacerbated in case of carry currencies. It seems that the market usually “overestimates” the magnitude and the life of the trend and prices in a “regime shift” The back end of the risk reversal is usually slightly overvalued according to the model. Observations about the risk reversal valuation with respect to implied volatility • When spot is trading in a range. Observations about risk reversal valuation with respect to realized volatility • We observe that the realized skew of the return distribution is less on an absolute value basis in most currency pairs than implied by the risk reversal contracts. given that we look at daily changes and do separate the upmoves from the down moves we have eliminated the first order issues with assuming the relationship to be linear. however from time to time we find that risk reversals become over or undervalued. after the event the implied skew continues to be higher and the market overestimates the possibility of the regime shift continuing and also becomes more willing to pay the insurance premium via the difference between the implied and the realized skew.remember that in any standard asset • • 17 .

Past performance is not indicative of future returns. interest rate differential. On another front. We could also make some distributional assumptions about the skewed currency pairs. Yet another application of the skew analysis could be to use them in conjunction with the carry trade(s) since they appear to be closely related. Price and availability are subject to change without notice. A cross sectional model using a spot range breakout indicator. country default probability and current account deficits might be an interesting extension. It is based on information generally available to the public from sources believed to be reliable. The issue of the risk premium in currencies remains a thorny one and as practitioners.pricing model such as the CAPM. It is not an offer. We could correct for constant interest rate assumptions in our model. there are other easier and more fruitful improvements at hand. any departure from normality costs computation times and increases complexity. No representation is made that it is accurate or complete or that any returns indicated will be achieved. Additional information is available upon request. Rachel and Manu . Changes to assumptions may have a material impact on any returns detailed. recommendation or solicitation to buy or sell. It would also be interesting to extend this analysis to emerging markets since the “risk factors” there are more apparent. we are interested in the “basic risk factors” as long as they either help us in hedging them or in terms of any predictive or return explanatory powers. the ICAPM or APT. while computing the realized skew. Risk Reversal Summary Table Currency Pair EURUSD GBPUSD NZDUSD GBPJPY AUDJPY AUDUSD USDCAD EURCHF EURJPY USDCHF USDJPY Risk Reversal* Overvalued Overvalued Undervalued Overvalued Fairly valued Fairly valued Fairly valued Fairly valued Overvalued Overvalued Overvalued *1m risk reversal valued wrt implied vol This has been prepared solely for informational purposes. Obviously. nor is it an official confirmation of terms. Dedicated to Mom. However. we need covariance with the consumption portfolio (proxied by various “factors” usually). we could develop a cross sectional model that would enable us to compare risk reversals across currency pairs and identify common characteristics leading to risk reversal portfolio opportunities or trading models.