The Impact Of Crises On Foreign Exchange Volatility
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The Impact Of Crises On Foreign Exchange Volatility


In the light of the terrorist attacks in the U.S. on Sept. 11 we try to identify the volatility market's typical reaction to international crises. We look at both realized and implied volatility and study a sample of eight crises spread over 30 years.

We concentrate on one-month volatility, as it is the most reactive to shocks. We first present the results of our analysis for both realized and implied volatility and attempt to draw parallels with the current situation.


Crises Impact On Realized Volatility

Table 1 displays the absolute change in historical volatility, which accompanied the major international crises, starting with the first oil shock.

During the first petroleum crisis, realized volatility decreased with a three-month horizon, with the exception of dollar/yen. This rather counterintuitive result is mainly due to the fact that this crisis was spread over time and spot's response was lagged: volatility eventually came up, but over a six-month time frame.

The second oil shock does not seem to have had such a major impact on the currency market and volatility went down rather than up during that period.

Subsequent crises had a much more homogeneous outcome with one exception, the Gulf War. The 1987 crash, the Exchange Rate Mechanism crisis (starting in September 1992 with sterling and the Italian lira dropping out), the Tequila hangover, Asian flu and the Russian crisis all involved speculative flows and all generated substantial volatility in the spot market. Furthermore, developments in the major currency pairs share some common characteristics. For instance, dollar/Swiss experienced some of the largest volatility movements as the swissie is usually regarded as a safe haven. Dollar/Deutsche mark realized volatility also proved prone to sharp moves under these circumstances, whereas dollar/yen was on average the least volatile of the currencies studied. However, dollar/yen's reaction to crises is disparate. Volatility decreased during the ERM crisis and the Asian crisis, but rose by the largest amount during the Russian crisis.

Table 1: Absolute Change In One-Month Historical Volatility
First Oil Shock 1973
After 1m -1.46% -2.25US% 0.08US% -5.36US%
After 2m -0.15US% 0.19US% 5.29US% 1.45US%
After 3m -1.21US% -2.38US% -2.43US% -5.72US%
Second Oil Shock 1979
After 1m -3.12US% -11.13US% -3.67US% -8.99US%
After 2m -6.34US% -12.90US% -8.32US% -11.70US%
After 3m -6.22US% -14.94US% -6.34US% -12.30US%
1987 Crash
After 1m 7.16US% 10.66US% 4.60US% 9.93US%
After 2m 3.82US% 4.25US% 1.18US% 4.72US%
After 3m 8.39US% 11.90US% 11.51US% 10.56US%
Gulf War 1990
After 1m -4.51US% -3.46US% -0.04US% -4.41US%
After 2m -4.43US% -5.79US% -2.14US% -6.29US%
After 3m 2.84US% 2.34US% 1.95US% 0.42US%
ERM – Starting with Danish Referendum June 1992
After 1m -3.53US% -3.25US% -4.01US% -3.12US%
After 2m 1.81US% 1.31US% -2.57US% 2.25US%
After 3m 0.36US% 0.91US% -3.23US% -0.81US%
ERM -Starting in Sep 1992 (GBP and ITL Drop Out)
After 1m 11.87US% 7.92US% 3.64US% 12.56US%
After 2m 7.91US% 6.56US% 2.95US% 8.05US%
After 3m 4.57US% 0.58US% 1.14US% 2.15US%
Mexican Crisis (Tequila Hangover) 1994
After 1m 2.86US% 1.86US% 2.39US% 3.55US%
After 2m 3.67US% 2.36US% 0.26US% 2.89US%
After 3m 9.70US% 11.05US% 6.94US% 9.97US%
Asian Crisis 1998
After 1m 5.82US% 0.78US% -5.53US% 0.83US%
After 2m 6.73US% 4.49US% -0.81US% 5.90US%
After 3m 5.38US% 1.90US% -2.77US% 2.11US%
Russian Crisis 1998
After 1m 1.87US% 6.07US% 17.11US% 5.39US%
After 2m 2.80US% 8.81US% 19.98US% 5.45US%
After 3m 0.92US% 5.55US% 9.63US% 3.37US%
Source: Lehman Brothers

The Gulf War is perhaps the most relevant example to try to understand the current situation, since it involves a U.S. led military intervention. When Iraq invaded Kuwait in August 1990 volatility first went up because of worries that the world's supply of oil would be disrupted. After that it consolidated during the fall and started increasing again in December to reach a peak in January as tensions mounted. When the coalition intervened on Jan. 16 volatility started to decrease and the bearish trend lasted until the end of the military strikes. Interestingly volatility started climbing again immediately afterwards.


Crises Impact On Implied Volatility

Table 2 displays the absolute change in implied volatility, which accompanied all the major international crises since 1992, starting with the ERM debacle.

Table 2: Absolute Change In One-Month Implied Volatility
ERM – Starting with Danish Referendum
After 1m 1.23% 1.18% 0.05% -1.05%
After 2m 1.60% 1.20% -1.05% 0.75%
After 3m 3.00% 3.00% 0.25% 1.70%
ERM –Starting in Sep 1992 (GBP and ITL Drop Out)
After 1m 6.53% 6.55% 2.80% 7.60%
After 2m 3.65% 6.30% 1.00% 3.45%
After 3m 1.90% 2.45% -1.98% 2.05%
Mexican Crisis (Tequila Hangover) 1994
After 1m 2.00% 1.40% 1.80% 2.55%
After 2m 1.90% 1.60% 1.70% 2.00%
After 3m 7.45% 6.85% 8.35% 4.80%
Asian Crisis 1998
After 1m 2.30% 1.10% 1.40% 1.00%
After 2m 3.70% 1.90% 3.45% 2.70%
After 3m 2.30% 1.40% 1.80% 2.05%
Russian Crisis 1998
After 1m 3.90% 2.15% 2.75% 2.95%
After 2m 4.45% 4.25% 10.85% 9.40%
After 3m 0.60% 0.95% 1.05% 1.05%
Source: Lehman Brothers

The results are more homogenous than they are for historical volatility, implied volatility in all currencies increased during the crises. The largest moves were seen in the aftermath of the Mexican and Russian crises, with implied volatility rising more than 10% in some instances. Overall euro/dollar was the most affected pair, followed by euro/yen, cable and dollar/yen.

More generally implied volatility across currencies usually starts rising just after the crises trigger event and well before realized volatility. Similarly, implied vols in all currencies start to come off in concert after having reached the peak of the crisis whereas the situation is more varied for realized volatility. This pattern might be due to the general level of risk aversion. Market players buy volatility across the board whenever they feel a crisis is about to materialize and they sell volatility simultaneously in all affected currencies when they feel that the danger has subsided.


New York Terrorist Attack's Impact To Date

Table 3 displays the absolute change in implied volatility and realized volatility observed since Tuesday, September 11, 2001.

Table 3: Absolute Change In One-Month Volatility From 11-25 September
Implied Vol. 2.00% 0.40% 1.97% 1.25%
Realized Vol. 0.08% -0.48% -0.87% 1.71%
Source: Lehman Brothers

These early statistics are very much in line with our history of former crises. Implied volatility has spiked, euro/dollar is the most affected, but historical volatility has somewhat lagged for now, except for euro/yen. Time will now tell which type of scenario will unfold:

If the markets stabilize around current levels, implied volatility should drop back more in line with historical.

However, if tension mounts and risk aversion increases markedly, implied volatility should still have a lot of upward potential. Furthermore, realized volatility which has remained almost stable so far could jump dramatically (a double-digit increase is a possibility).



Realized volatility has reacted very differently to the various crises. Financial crises such as the 1987 crash, the ERM crisis or the Russian crisis seem to generate the largest amount of volatility. On the other hand, the U.S. led military intervention in the Persian Gulf War caused realized volatility to soften.

Implied volatility responds more homogeneously to crises. It rises across all currencies quickly after any trigger event.

So far, the current spike in volatility is consistent with previous crises. We believe that there still is a large upside potential for both realized and implied vol, should the situation deteriorate further. Market players should remain cautious.

This week's Learning Curve was written by Anne Sanciaume, foreign exchange strategist at Lehman Brothersin London.

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