Where Has All The EUR Tail-Risk Gone?
Everyone and their dog is by now well aware of the stress in Europe - and implicitly the chance for a major tail-risk event occurring. Yet, as Citi's Steven Englander notes, the amount of tail risk that is actually priced in is astonishingly small. Whether it is risk-reversals (which are skewing increasingly towards EUR strength relative to the USD) or Digital options (which are essentially the market's oddsmaker for a big - 15% or more - move in the currency), it appears investors are gravitating to a view that the sovereign crisis will play out in debt markets more than in currency markets. We agree with Englander when he notes "this looks to be an extremely hopeful view of how events will play out". His suspicion is that investor rhetoric is more dire than their willingness to buy insurance.
Risk/reversals (the bias in put and call option prices) appears to be pricing in EUR strength (rising black line recently)...
but we note (the orange oval) that we have seen these periods of risk-reversal-based hope come and go recently with LTRO belief fading very quickly.
...and consider the chart below where we chart 15% out of the money forward six month digitals. Essentially these are the implied probabilities from options markets that the currency will move 15% or more over the next six months. Admittedly somewhat arbitrary, this seems to capture the essence of what we mean by tail risk.
The current premium for a view that the euro will be 15% cheaper in six months is about 7.4% (we use Bloomberg mid-pricing so these should be viewed as approximate). But the price for a bet that the euro will be 15% more expensive in six months is 4% so beyond the normal volatility there is maybe a 3% excess probability priced in for a really big euro move. By comparison the premium on USDCAD moving up by 15% or more over six months is 8%, and the cost of an AUDUSD 1.14 6m digital is 4%. Pricing for a similar USDJPY upside digital is 6.3%.
For a crisis that dominates asset market moves and discussion, the actual risk that is priced into the tail seems remarkably low. Gauss may be triumphing over good sense once again.
Relative to periods of stress over the last year, today’s pricing of a big move is on the modest side. Premium for 15% EURUSD downside were over 11% in October and November of last year.
Expectations appear to be converging on a view that the outcome will be
1) a benignly managed Greek exit
2) more stress on Spain, italy and other euro zone countries, leading to...
3) stronger ring fencing of the remaining euro membership.
Investors may be distinguishing between scenarios in which there is sovereign stress, which is very likely, and EUR stress, which they think is less likely if Greece stays in or is managed out gracefully. Whether this is a realistic scenario is another question, and given the German unwillingness (and quite possibly inability) to underwrite the rest of the euro zone, the risk of contagion and EUR weakness may be much bigger than what is now priced in.
Source: Citi/Steven Englander