There is always demand in the foreign exchange market to determine market positioning as a guide to the near term pressures on a currency. This is because if the short term speculative market is long in a particular currency, then there is an increased risk these positions will be reversed and there will be a sharp move lower. The data on international money markets (IMM) positioning will give some indication on the speculative stance of the market, but it only represents a small part of the marketplace. In addition, it only provides information on Friday for market positioning up to the previous Tuesday. By Monday morning, when the figures are widely known, the data are nearly a week out of date.
As a result, foreign exchange practitioners also use the risk reversal bias to judge the market's current positioning and hence the balance of pressures in the spot market ahead of the next move in prices. If the risk reversal shows a high bias for calls we can infer that further currency appreciation may be difficult, even if there is 'good news' as the market is already positioned for such a move. In order to judge whether the bias is high or low, we compare it to recent levels through noting the latest 10 day average and the historical levels of the risk reversal skew.
The risk reversal skew is defined as the bias between 25-delta puts and calls in the interbank foreign exchange options market, in terms of the base currency shown. Data are given for the bid side of the market. A positive bias reflects a bias in favor of calls for the base currency. This skew reflects how the option market is pricing the risks of higher or lower volatility for a given spot move. For example, a risk reversal bias for puts infers implied volatility is expected to rise as spot falls--the demand for puts vis-à-vis calls has increased in anticipation of this risk, pushing up the volatility for 25-delta puts compared with 25-delta calls. At the same time, such a put bias implies volatility will fall as spot rises. This is because the market is left long puts vis-à-vis calls and may have to review volatility expectations by selling some of the purchased puts if spot continues to rise. A bias for calls infers the opposite volatility effect, ie higher spot means higher volatility.
At the start of last week there were two notable features of the risk reversals positions for the currency majors. These were extended positions on euro/dollar and dollar/Canadian dollar.
For euro/dollar on Monday, the one-month risk reversal was 1.1 and the 10 day average was 0.65. As Graph 1 indicates this was an extreme reading that would indicate the market was already strongly positioned for a move higher. The one-month risk reversal skew had jumped back toward an extreme reading after a gradual decline toward the average over the previous three weeks. This came as a result of the shock news the previous Friday that U.S. Treasury Secretary Paul O'Neill and Larry Lindsey, director of the National Economic Council, had resigned and the resultant debate over the Bush administrations' strong dollar policy. The risk reversal cone or curve (the one-week to 12-month risk reversal, or the options equivalent of the yield curve) was just short of the highest 5% of readings taken over the last two years, indicating that an upside move was already discounted. There could have been some scope for additional gains, but it was more likely that a reversal would be necessary before this could be seen. Implied volatility also leapt higher, particularly in relation to the change in actual volatility. This was another indication that things may have extended a little too far as the divergence was indicative of a jump in options prices in anticipation of future volatility.
These indications from the options market have been a good sign that the 1.0170/1.0235 would be very difficult to break on the upside without additional positive information and that a period of consolidation or correction would probably be necessary before there could be an additional move higher. This could argue for profit taking on long euro/dollar positions or the creation of short-term speculative short positions.
On Monday, dollar/Canadian risk reversals had also moved to an extreme position in favor of dollar puts. The one-month risk reversal was minus 0.25 and the 10 day average was minus 0.20. This does not look extended in absolute terms but compared to the historic norm that is usually biased for dollar calls, this is an extreme reading (see Graph 2). The continued evidence of strength in the Canadian economy and the perceived risk that the Canadian-U.S. interest rate differential would increase were behind this negative move on dollar/Canadian. This extreme reading would appear to have been a constraint on additional dollar/Canadian losses. The options market here was consistent with the evidence from the IMM that short position had become very extended to the downside according to the data that were released on Dec. 6 for the period up to Dec. 3. In total, these indicators would act to reinforce the belief that very solid support in the CAD1.5550 area would be difficult to break and would argue that a period of consolidation was likely to be necessary before a further move lower could be seen. This would argue for profit taking on shorts or more tentative establishment of speculative longs.
This week's Learning Curve was written by Rob Hayward, senior foreign exchange strategist at ABN AMROin London.
