Where Has All The EUR Tail-Risk Gone?

Tyler Durden's picture


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

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Wed, 06/27/2012 - 10:53 | 2565007 veyron
veyron's picture

Just going to sit back and continue to watch this mess unfold... any recommendations for soft pretzels?

Wed, 06/27/2012 - 10:53 | 2565010 battle axe
battle axe's picture

Euro at par by Dec. Maybe lower.....

Wed, 06/27/2012 - 10:58 | 2565026 GeneMarchbanks
GeneMarchbanks's picture

Man I hope you're right, not because I have that trade on just because that would would really reflect the strong dollar policy being currently implemented.

Wed, 06/27/2012 - 11:14 | 2565067 ZeroPower
ZeroPower's picture

Heard this in the summer of 2010 when EURUSD was just under 12000s. 

The Euro will be where it will be at Dec. While i'm betting it will be lower than the current spot, i don't see it getting close to parity as the FX dealers need room to run stops both ways as they do in their normal day to day lines of work.

Wed, 06/27/2012 - 11:49 | 2565184 Carl Spackler
Carl Spackler's picture

Dollar parity by December?

If that is the case at that time, then the Deutsche Mark will have been resurrected.


Wed, 06/27/2012 - 10:54 | 2565014 fonzannoon
fonzannoon's picture

This is just a constant slaughtering of shorts. Lure them in with horrific macro info and then squeeze them until they pop.

Wed, 06/27/2012 - 11:10 | 2565054 Village Smithy
Village Smithy's picture

I agree, the short squeeze manipulation carried out with ZIRP and condoned by all CBs is a big factor. No doubt Tyler is gathering data and will soon present the facts.

Wed, 06/27/2012 - 10:55 | 2565018 GeneMarchbanks
GeneMarchbanks's picture

'appears investors are gravitating to a view that the sovereign crisis will play out in debt markets more than in currency markets.'

That would make perfect sense actually.

Wed, 06/27/2012 - 10:56 | 2565020 midgetrannyporn
midgetrannyporn's picture

zero hedge is what is going on. fat tail is a myth.

Wed, 06/27/2012 - 11:01 | 2565033 Dr. Engali
Dr. Engali's picture

Too many paople are relying on the printers. Failure to hedge thinking the printers will save them is going to be painful.

Wed, 06/27/2012 - 11:06 | 2565049 BeetleBailey
BeetleBailey's picture

My recommendation?

Short EUR/USD @ 1.2715 post unicorn euphoria ka ka from the EU circle jerk

.....hold...carry trade.....EUR/USD @ 1.20 by 9/15...........

Wed, 06/27/2012 - 11:12 | 2565059 geewhiz190
geewhiz190's picture

it may be that swiss intervention, which has been massive, could account for the euro's seeming lack of response to events. i wonder what, if any, limit the swiss central bank will put on battling the euro's decline. it may also be possible that the chinese would be unhappy with a weaker euro, but what they could do is more problematic

Wed, 06/27/2012 - 11:18 | 2565085 HaroldWang
HaroldWang's picture

Priced into what??? Last I looked SPX is not far off it's high of the year. Earnings are going to be awful this Q. None of that is priced in let alone a major crisis in Europe.

Wed, 06/27/2012 - 11:21 | 2565094 Ellindian
Ellindian's picture

there is no single currencly in the world for a reason..currencies are like flags. you cant have faith in the one without faith in the other...
Sell the damn thing...

Wed, 06/27/2012 - 11:37 | 2565154 xcehn
xcehn's picture

With everything so extremely manipulated and rampant propaganda, the only safe bet is PM and cash of some sort. How the herd moves is the last thing I think about.

Wed, 06/27/2012 - 15:36 | 2566059 Goldilocks
Goldilocks's picture

Pete Seeger: Where Have All the Flowers Gone?
http://www.youtube.com/watch?v=1y2SIIeqy34 (4:23)

Marlene Dietrich - Where Have All The Flowers Gone?
http://www.youtube.com/watch?v=f_ptqXqjsZw (3:39)

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