The Icelandic krona fell 10% against the euro in less than 36 hours last week, prompting a rush to buy up options on the pair. Fitch Ratings Tuesday downgraded its outlook on Iceland and one-month implied volatility jumped to 17% from 10% before the downgrade with spot dropping to ISK82.01 Wednesday. By Thursday as DW went to press, the krona had recovered somewhat to ISK79.3857.
Funds which had loaded up on krona by borrowing in euros rushed to close out positions in the spot market. To lessen losses, hedge funds were buying one-month puts and calls on the pair to profit from the volatility spike. Options with strikes ranging from ISK75 to ISK82 were popular, with short-dated options breaking even quickly.
The attraction of Iceland's 10% interest rate meant carry trades were behind most of the flows on the pair, said one trader. "Those guys were panicking," he said, noting Thursday trading on the pair had settled. Krona-related pandemonium contaminated other high-yielding currencies, and the rand and real also tumbled against the euro and U.S. dollar.
Klaus Papenbrock, fx strategist at Deutsche Bank in Frankfurt, said it is hard to tell whether last week's collapse in the krona marked a turning point for the currency. "I would tend to believe we could see a stronger currency again if the rate hike cycle is not over," he said. "But the last few days might be a fore-taste of what might happen when the cycle is over," he added.