Buy EUR/USD skew against EUR/JPY - SocGen

Olivier Korber, Research Analyst at Societe Generale, suggests that the revived US election risk created an unusual pattern seeing a weaker dollar combined with higher FX volatility, creating opportunities in skew space.

Key Quotes

“JPY and EUR calls are now both in high demand, lifting JPY skews but pressuring EUR/USD risk reversals.

The spread between EUR/JPY and EUR/USD 3m risk reversals is now very elevated historically and we expect it to tighten. It never reached 1.5 vols between 2012 and 2015 and such a situation happened only very transitorily this year.

Flat EUR/USD skew: not an anomaly but not sustainable. Such as pattern is indeed consistent with no correlation between spot moves and volatility changes, and this is exactly what is happening in the EUR/USD option market. This correlation is usually negative, and we expect the US election to be dollar-friendly and to support volatility.

Sell EUR/JPY rather than USD/JPY skew. Yen calls are in high demand as the market is behaving in a risk-off way. Yen strength probably met an inflexion point. The EUR/JPY 3m skew is larger than the USD/JPY (-2.0 vs -1.7, mid), so that selling the former provides a higher premium. Moreover, a EUR/JPY skew exceeding the USD/JPY is not consistent in times of EUR topside volatility. On the contrary, euro bullishness should have dampened the EUR/JPY skew, which is an attractive Sell.

Expression: Sell EUR/JPY rather than USD/JPY skew

Selling outright yen volatility or skew is not a reasonable trade given the imminent risk event, but selling the yen skew premium as a leg of a volatility relative value trade appeals.

Mechanics: Buy EUR/USD 3m risk reversal / Sell EUR/JPY 3m risk reversal

Dynamically delta-hedged

Indicative bid for the spread: receive 1.4 vols

Risks further skew divergence

Investors selling delta-hedged options face unlimited downside convexity. The trade is essentially exposed to the implied volatilities of the options constituting the two risk reversal strategies. Namely, the mark-to-market is at risk if EUR/JPY puts become more expensive in volatility terms, and/or EUR/USD puts less expensive.”