Skew Guide

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DB Guide to Risk Reversals
19
th
October 2006

Inside:

Skew Analysis

Risk reversal
valuation
methodology

G-10 risk reversals

Analysis of model

Valuation Summary
Table

Apurv Jain

Mark Stafford

212-250-8060
How to value risk reversal contracts and identify
relative value trading opportunities
We link skewness of the FX spot return distribution to the
risk reversal contract and propose a methodology to value
risk reversals with respect to implied and realized
volatility to find relative value trading opportunities
In most cases realized skewness of the distribution is less
on an absolute value basis than the implied skew

We observe that a sharp movement in spot is usually
followed by a risk reversal overvaluation as risk
premium increases and implied skew in the following
periods is higher than realized skewness of the
distribution. Additionally, the back end risk reversals tend
to exhibit more overvaluation

We also discuss applications of conditional variance
swaps as a means of taking advantage of the risk
premium
O
N
1
m
3
m
1
y
10p
DN
10c
6
7
8
9
Implied vol
Time
Strike
Skew

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Deutsche Bank

We link skewness of the FX spot return
distribution to the risk reversal contract and
propose a methodology to value risk reversal with
respect to implied and realized volatility to find
relative value trading opportunities
In most cases realized skew is less on an absolute
value basis than the implied skew
We also observe that a sharp movement in spot is
usually followed by a risk reversal overvaluation
as risk premium increases and implied skew in
the following periods is higher than realized skew.
Additionally, the back end risk reversals tend to
exhibit more overvaluation
We also discuss applications of conditional
variance swaps as a means of taking advantage of
the risk premium
Introduction
The famous Black Scholes model for option pricing
has a questionable assumption of constant volatility
of the return distribution, which doesnt hold up to
empirical examination. In fact there is well
documented correlation between spot levels and
the implied volatility levels. This correlation which
results in the well known smile or a smirk effect in
options on various asset classes is also included in
the new and more complex models of option
pricing. Risk reversals are liquid instruments that
allow exposure to this correlation between volatility
and spot levels.

In this article, we propose a simple methodology to
value risk reversals and propose trade ideas based
on those valuations. We take USDJPY as an
example to walk through the analysis.

Skew- an intuitive explanation
Skew means that the return distribution will be
asymmetric and the left or the right tail is heavier.
The absence of skew means that a distribution, for
example the normal distribution, will be symmetric
with both tails having the same weight. As an
illustration of the concept, notice in fig. 1, the lighter
distribution has a left tail that is heavier than the
darker colored normal distribution. The lighter
distribution is referred to as a negatively skewed
distribution.

In options markets, a thicker left tail of the return
distribution means that OTM put options have a
higher probability of finishing in the money as
compared to an OTM call with the same delta. The
delta of an option, which is an approximation of the
probability of the option finishing in the money, is
computed under Black Scholes by assuming that
the return distribution is normal. This phenomenon
of skew has been observed in other markets as well
- wherever there is correlation between implied
volatility and spot we will see a skew. In the case of
equity indices, falls in equity prices are accompanied
by sharp increases in volatility. Even if the spot rate
is kept constant, an increase in volatility makes an
option more expensive since the price of a
European or American style option always increases
as volatility increases. So naturally, if volatility
increases as the spot level falls, the value of the put
option increases even more than would be
expected with a mere decrease in spot levels. The
mechanism described above gives rise to the
skew in the implied distribution. The implied
distribution is what the market expects and the
realized distribution is what really happened.
To the extent that implied and realized distributions
diverge systematically and consistently, we conclude
there is a risk premium. The presence of a risk
premium is usually accompanied by a trading
opportunity. Now imagine the case where on average
the expected (risk neutral) correlation between
implied volatility and spot levels implied by the
distribution is on average similar to the correlation
observed in reality, over time we would say there is
no risk premium. However, if we see that the
market consistently prices in a different correlation
Fig 1. The light distribution has a negative skew
and the dark one is normally distributed

Fig 2. Out of money puts and deep in the money
calls in equities are more expensive
S&P 500 Dec 2006 Option Strike vs. Implied Vol
10
10.5
11
11.5
12
12.5
13
13.5
1330 1340 1350 1360 ATM 1380 1385
Strike
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Source: Bloomberg, DB FX Research
Skew Analysis
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Deutsche Bank@
3
between volatility and spot levels than is observed
then there is a skew risk premium This skew risk
premium is in addition to any insurance premium
the writer of the put option might charge.

Does USDJPY have a skew?
When we examine the scatter plot of implied
volatility and spot level we see that there is a
negative correlation between spot level and implied
volatility which is statistically significant. This results
in the left tail of the returns being thicker as or a
negative skew as explained above.

What is a risk reversal?
A risk reversal is a contract which is long 1 unit of a
call option (typically 25 delta call option) and short 1
unit of a same delta put option (25 delta put option.
Taking the example of USDJPY, a one month 25
delta risk-reversal would be long a one month 118.34
strike USDJPY call and short a 114.77 strike USDJPY
put. The implied volatility of the call option (mid
market) is 7.43% vs. the put option volatility of
8.03% (spot ref 117.09, ATM volatility 7.6). The
difference between the implied volatilities of options
with different strikes is called the volatility smirk or
smile. This shows that the market price of dollar puts
with roughly the same probability of finishing in the
money is higher than the price of dollar calls with the
same probability of finishing in the money. The
explanation for the price difference between the calls
and the puts follows directly from the explanation
given above about the correlation between spot level
and volatility. Essentially a risk reversal contract helps
take positions on the spotvol correlation in addition
to a directional bet. Naturally, if the portfolio is delta
hedged continuously then the trade only expresses a
spot-vol correlation view. It can also be thought about
as expressing a dvega/dspot view which means a
small change in the vega of the option portfolio given
a small change in spot level, holding everything else
constant.

How can we see if USDJPY risk reversal is fairly
valued?
Naturally, this leads us to the question if this is
justified. There are two aspects to the question
first, if the risk reversal is fairly valued with respect to
implied volatility and the second, if the risk reversal is
fairly valued with respect to realized volatility.
Essentially, these questions mean that if the market
participant hedged out the contract such that only
exposure to volatility remained then what kind of
returns would their portfolios show. In one instance
(implied volatility) is how the portfolio would be
marked to market and hence no systematic return
would be made unless there was a correlation
between the spot return and the implied volatility. In
another instance, if the portfolio was held to maturity
then no systematic return would be made less there
were a correlation with realized volatility. In other
words, in the first instance we are testing an
implied skew behavior and in the second we test
the realized skew behavior.

Fig 3. USDJPY implied volatility smirk means dollar
puts/yen calls are more expensive
USDJPY skew
7
7.5
8
8.5
9
9.5
10P 25P DN 25C 10C
Strikes
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Fig 4. USDJPY spot and implied volatility exhibit a
negative correlation in the past sample (1997-2001)
y = -0.1459x + 0.0632
R
2
= 0.0795
-8
-6
-4
-2
0
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-15 -10 -5 0 5 10 15
1 month change in USDJPY Spot
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Fig 5. spot vs. implied volatility negative correlation
continues in the present sample (Jan 2002-Sep 2006)
y = -0.1562x - 0.0509
R
2
= 0.1756
-8
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1 month change in USDJPY Spot
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Is the risk reversal fairly valued with respect to
implied volatility? (USDJPY as an example)
To answer this question, we start with a broad
assumption that a risk reversal is fairly valued if the
implied volatility of a particular strike option remains
constant. Continuing with the example above, say
the USDJPY spot level falls from 117.09 to 114.77,
and the at the money forward volatility increases to
8.03% from 7.6% and similarly, when spot rallies to
118.34 if the at the money volatility goes to 7.43%,
then we consider the risk reversal to be fairly valued.

Naturally this is a rather simple assumption (also
known as sticky by strike). However, given that we
look at the local changes in spot every day and the
related changes in implied volatility accompanying it,
this seems to be reasonable. We record the data
sample of spot and implied volatility moves into two
samples - spot upmoves and spot down-moves.

We take the up-moves sample and measure the
change in spot and the related changes in the implied
volatility. We perform a regression to get the
coefficient
upmove
which tells us how much implied
volatility moves per unit of spot movement up.
Naturally, in case of USDJPY this coefficient is
negative since as spot rallies the implied volatility
usually sells off.

We perform a similar analysis on the down move
sample and get the
downmove
which is the coefficient of
the change in implied volatility when spot sells off.
Note, that this coefficient will also be negative since a
spot sell off usually results in an implied volatility
rally. To compute the coefficients we use the data
for the last 3 months. We tried different time windows
for computing the coefficients and found that the 3
month gave the best results (as measured by the
least amount of squared pricing errors). We then
compute how far out of the money the call and the
put options are (125 pips for the USDJPY call and
232 pips for the USDJPY put in the above example).
And then we calculate the value of the risk reversal
with the following formula

We look at data from January 2000 to August 2006
and find that the risk reversal seems reasonably
correctly valued. There are times when the model
value and the market value of the risk reversal
diverge and those might be trading opportunities. For
example through a large part of 2004 the front end
risk reversals were overvalued with respect to
implied volatility. Any trading strategy based on that
would take advantage of this model valuation to
generate positive returns. As can be seen from fig 6,
our model captures the various movements in the
price of the risk reversal, which is a true test of how
good this simple model is.

Fig 7. The 10 delta risk reversal is overvalued with
respect to implied volatility

Fig 6.The 25 delta risk reversal in the front end is
overvalued
-7.00
-6.00
-5.00
-4.00
-3.00
-2.00
-1.00
-
1.00
2.00
3.00
4.00
Jan-
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Jun-
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Nov-
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Apr-
01
Sep-
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Feb-
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Jul-
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Dec-
02
May-
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Oct-
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Mar-
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Aug-
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Jan-
05
Jun-
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Nov-
05
Apr-
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25del Model Value
25del Price

Value of risk reversal =
upmove*
Out of moneyness
of call -
downmove
*Out of moneyness of put
Deutsche Bank@
5
Is the risk reversal fairly valued with respect to
realized volatility?
Now we try to answer the question of does the
portfolio of long one unit 25 delta call and short one
unit 25 delta put pay off if held to maturity. Notice, in
the earlier case, we evaluated the question of if spot
moved instantaneously and one were to sell the
portfolio (having hedged all other risks but volatility
risk) then would the return on the portfolio be
positive. In the earlier case the only volatility one
cared about was the implied volatility since we
assume that only a very small interval of time passes
before the portfolio is revalued and hence the
exposure to realized volatility is minimal. Now we
examine if the realized volatility shows any
correlation with the spot levels. In other words is the
realized skew equal to the implied skew of the
distribution.

For this we use some of the well known results in
financial literature from Breeden and Litzenberger
(1978) to infer the risk neutral distribution of the
returns from the option prices. The formula derived
for the relationship between the implied skew and
the risk reversal is as follows:

Here t is the time to maturity and n the evaluation time.

This formula enables us to compute the risk neutral
implied skew from the risk reversal prices. Then we
take the actual log returns of the USDJPY spot and
compute the skew of that distribution. If the returns
were indeed normally distributed, then the skew
should be zero- in other words the distribution should
be symmetric and there should be no correlation
between spot level and volatility. The results in fig. 8
show that the realized skew is always higher than
the implied skew or that in this small sample, the
portfolio produces positive returns. In other words
selling dollar puts and buying dollar calls produces
positive returns for the market maker when the
investor buys insurance."

Why does being long USD calls / short USD puts
in USDJPY produce a positive return? Implied
volatility has a risk premium built in it in addition to
the future expected realized volatility. The time
period of the data (Apr 03 July06) is a small
sample in that there is no event when the yen
appreciated with a shock.

Essentially, the strategy that systematically sells
dollar puts provides insurance against the possibility
of a big sell off in spot. A deeper question remains- is
the risk premium justified? I.e. is the volatility risk
premium merely a convenience cost (i.e.

Fig 10. And naturally the realized risk reversal has a
higher value than the implied
USDJPY Realized vs. Implied Risk reversal
-4.00
-3.00
-2.00
-1.00
0.00
1.00
2.00
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Realized Riskie Implied Risk Reversal

Fig 8. Realized volatility and spot had a similar
negative relationship from 1997-2001
y = -0.3364x + 0.0625
R
2
= 0.0488
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1 month change in mean USDJPY Spot
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Fig 9. However, since 2002 this relationship has
broken down
y = 0.0252x + 0.0106
R
2
= 0.0006
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Skew
t,n
= 4.4478* RiskReversal
t,n
(25)/At The
Money Volatility
t,n

the amount of money you pay to not have to
synthetically manage your portfolio to create a call
option) or is there a covariance with a risk factor
involved. An interesting insight is that yen rallies,
carry trade unwinds and bouts of risk aversion are all
correlated. Naturally, when the market is more risk
averse, it is willing to pay a higher insurance
premium for the same risk. However, the central
question remains- What is the real macroeconomic
risk? an example could be a global recession risk
due to a US current account deficit.

How can we use variance swaps to take
advantage of the risk premium? The data makes
us think that a smart way to trade yen volatility would
be to be long only implied volatility and skew and sell
the realized volatility and skew.

A simple variance swap pay off is just the difference
between the implied and realized variance.

Now structures like the conditional variance swap
utilize the spot and volatility correlation to improve
the volatility break even and the contract is
structured as follows:

Mathematically the pay off can be expressed as:

Here if i-1th spot fixing is below the level H then
H S
i
<
1
1
= 0 and if it is above then = 1

How do the suggested trades take advantage of
the risk premium?
The short conditional variance swap leg enables
selling the realized volatility when spot sells off,
which is usually lower than the market implied
volatility and has little relation to spot level.
Essentially, the conditional variance swap collects the
risk premium when spot sells off, which is results in
positive returns. In a low volatility environment a
conditional variance swap is an ideal way to leverage
a core view that volatility will pick up over the coming
months.

Any increase in the uncertainty or increase in risk
premium as spot sells off or due to some macro
economic event will also favor this trade since
typically higher the risk aversion, the higher the
premium we collect and hence the better the strike
improvement. The BoJs stance on interest rates also
helps us determine the feasibility of the trade. As the
BoJ looks unlikely to raise rates soon, we are
confident of low realized volatility in the near future.
Not unnaturally, the carry trade is back.

In the rest of this piece we examine risk reversal
value for other G10 currency pairs.

2 2
Payoff
Strike Realised
=
=
<
|
|
.
|
\
|
N
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H S
S
S
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1
2
2
1
log 252 1
1
1
Payoff
1

If spot remains above 114 the variance
swap works in the usual way
If spot moves below 114, fixings below
114 do not contribute to the variance
calculation
Strike improvement of 0.6 vols from
8.85% to 8.25% in 1 year maturity
Deutsche Bank@
7
EURUSD

At the moment, our model says that the EURUSD
front end risk reversals which just switched sign
from being positive to negative at -0.2 vols for EUR
puts are slightly expensive. The back end (=1 year)
risk reversal at 0.35 vols is also somewhat over
priced with respect to implied volatility although it
has been tending towards fair value. The 1m 25 delta
strikes are 1.2380 and 1.2720 for vols of 6.8 and 6.55
respectively. We expect the implied to rally if spot
goes to 1.2380 and to sell off if spot retraces back to
1.2720 and be lower. However, we believe that the
market is overestimating the possibility of a regime
shift once more after a sharp spot move. So our
view is that the front end risk reversals are
somewhat overvalued.

Our analysis of risk reversal with respect to realized
volatility indicates that it is overvalued. The other
general finding is that risk reversals rarely pay for
themselves if they are higher than 0.5 vols. Unless,
we expect a big macro shock, we would prefer to be
a seller rather than a buyer at those levels. When we
have sharp and persistent divergences from the
model in the front or the back end it implies a trading
opportunity. When the risk reversal price produced
by the model consistently provides a value above the
current price, it means that the risk reversals are
cheap.- For example, at the moment EURUSD 1m
risk reversals are cheap.

Historically, in the middle of 2002 the risk reversals
were cheap with respect to implied volatility. That
pattern continued through that year and gradually
they returned to fair value in 2003.

Looking at EURUSD spot we see three main
regimes. Before 2002 EURUSD was in a downward
trend and after 2002 it was in an uptrend that lasted
until 2005. Since then it has traded sideways and is
in what we classify as the third regime. We observe
that risk reversals tend to trend with spot values. In
the first EUR bearish regime any spot moves lower
meant an increase in implied volatility. There was a
regime change in 2002, during which the risk
reversal changed from favoring EUR downside to
EUR upside and in the second regime EURUSD
moves up meant an increase in implied volatility. In
the third regime of EURUSD trading sideways we
see that EURUSD risk reversals are fairly valued and
spot increases still mean implied volatility increases.

Fig 11. From 1999-2002 EUR puts were better bid
and if spot fell, implied volatility rallied
y = -9.6956x - 0.0497
R
2
= 0.0355
-5
-4
-3
-2
-1
0
1
2
3
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-0.20 -0.10 0.00 0.10 0.20
1 month change in EURUSD Spot
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Fig 12. EURUSD spot regime change in 2002 led to
EUR calls being more expensive
EURUSD spot rate
0.8
0.9
1
1.1
1.2
1.3
1.4
1.5
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Fig 13. Front End EURUSD risk reversals are slightly
overvalued with respect to implied volatility
-8.00
-6.00
-4.00
-2.00
-
2.00
4.00
6.00
Jan-
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Nov-
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Apr-
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Sep-
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25 del Model Value
25 del Price

GBPUSD

GBP risk reversals have just flipped direction from
being bid for sterling calls to being bid for sterling
puts. They had been bid for sterling calls since 2001
when spot started trending higher. At the moment,
with the 1 month risk reversal at -0.18 favoring
downside, we think that the market has overreacted
with respect to the dollar rally and the probability of a
sharp dollar up move is less than implied by the risk
reversal. We agree that any GBPUSD rally is more
likely to result in spot being back in the range
which is bearish volatility, however according to our
model the odds are higher that the dollar up move is
subdued than is currently implied by the distribution.

At the moment we prefer to sell the USD calls and
buy USD puts and then wait to buy them back for a
small profit when the market prices in a lower
chance of a spot break and the risk reversal price
comes down. Until recently, the back end risk
reversals which were priced at 0.30 vols seemed
overvalued with respect to implied volatility.
However, with the recent move down to 0.2250 they
have come closer to being fairly valued.

Historically, GBPUSD implied volatility has rallied with
spot rallies, however realized volatility rarely tends to
follow. Although, GBPUSD traded sideways and then
mostly downward from 1996 to 2002, implied
volatility still rallied when spot moved up. This
indicates to us that the market might have been
overpricing the risk reversals in that period, or
attaching a large risk premium to a large dollar move
downward.

Notice, that the realized volatility and spot levels
display no significant relationship during the current
sample period of 1999-2005. This led to the realized
skew being quite low and hence the realized risk
reversal was overvalued for most of the 1999-2005
period. The simplest way to formulate a trading
strategy, based on the risk reversal model is to
examine periods when the model valuation is
significantly and persistently different from the actual
valuation. Naturally, if the model values are higher
than the risk reversal values, we like buying and if the
model values are lower than the current risk reversal
values, we like selling. For example in GBPUSD, we
note that in Sep 2002 buying risk reversals (buy GBP
calls / sell GBP puts) would have generated
substantial positive returns, as would have selling
them (sell GBP calls / buy GBP puts) in November
and December 2003.

When spot is in a trending cycle then risk reversals
tend to be have higher values, which may be
ascribed to overvaluation or possibly a higher risk

premium on a spot move up. In times of sideways
movement risk reversals tend to be reasonably
correctly valued, perhaps because people are
unwilling to buy vanilla options when they see
realized volatility being low and the expected realized
volatility in the near future is low as well. With little
speculative interest and little realized volatility the
price of the risk reversal decreases. Interestingly we
notice the pattern that the front end risk reversal is
close to fair value in these situations. However,
notice that the back end of the risk reversal is still
slightly overvalued according to the model. This
probably reflects a term structure of risk premium
which is upward sloping or liquidity and hedging
costs. Additionally, for this currency pair also we find
that when the risk reversals price gets to more than
0.5 vols they rarely tend to pay for themselves.

Fig. 14. The implied vol and spot correlation have a
positive relationship
y = 5.8963x - 0.0496
R
2
= 0.0927
-5
-4
-3
-2
-1
0
1
2
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4
5
-0.20 -0.10 0.00 0.10 0.20
1 month change in GBPUSD Spot
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Fig. 15. However, GBPUSD realized volatility has
shown no correlation to realized spot movements
y = -3.3271x + 0.0353
R
2
= 0.0022
-6
-4
-2
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-0.15 -0.10 -0.05 0.00 0.05 0.10 0.15
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Deutsche Bank@
9
NZDUSD

With the exception of USDJPY and the yen crosses,
NZDUSD exhibits the most extreme risk reversals in
the G10 FX world, between 0.5 and 1 vol favoring
kiwi puts.

The market preference for puts on the kiwi dollar is
due to the currencys position as the highest yielder
in the G10. With 1 year rates above 7.5%, long kiwi
dollar positions are naturally very popular with FX
carry traders. During bouts of risk aversion, these
carry trades are unwound dramatically and the
currency lurches lower, causing higher actual
volatility and higher implied volatility as traders
scramble to buy gamma to cover their positions.

We find that in our model, front end risk reversals are
undervalued with respect to moves in implied
volatility. However, as we shift to longer dated risk
reversals, we find that the market overestimates the
change in implied volatility when spot changes.
Additionally, as seen in fig. 17, the realized skew of
the NZDUSD distribution is a lot less negative in our
sample than implied by the value of the risk reversal.
This suggests the back-end Kiwi risk reversals are
overvalued both in terms of implied and realized
volatility moves.

This overvaluation becomes most apparent after the
early 2004 drawdown of 2003 carry trade (NZDUSD
up 30% in 03). Since mid 2004, rises in US rates
have reduced the interest rate differential and
removed the attraction of USD of a funding currency
thus reducing the interest in the NZDUSD carry
trade. The NZDUSD realized skew exceeded the
implied skew for a brief period when the NZD fell
sharply but it seems the longer dated risk reversals
priced in a regime change of falling spot and hence
they have not been worth it subsequently as they
have remained around 0.75 vols since 2004.

Fig 16. Realized skew is not as negative as implied
skew. Risk reversals rarely pay for themselves if
they exceed 0.5 vols
-2.50
-2.00
-1.50
-1.00
-0.50
0.00
0.50
1.00
1.50
2.00
2.50
Jan-
98
Aug-
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Mar-
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Oct-
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May-
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Sep-
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Apr-
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Nov-
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Jun-
04
Jan-
05
Aug-
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Mar-
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Realized Riskie Implied Risk Reversal

Fig 18. NZDUSD front end risk reversal is
undervalued with respect to implied volatility
-3.00
-2.50
-2.00
-1.50
-1.00
-0.50
-
0.50
1.00
1.50
2.00
Jan-
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Jul-
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Jan-
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Jul-
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Jan-
03
Jul-
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Jan-
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Jul-
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Jan-
05
Jul-
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Jan-
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Jul-
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25 del Model Value
25 del Price
Fig 17. Back End NZDUSD risk reversals are
overvalued with respect to implied volatility
-1.50
-1.00
-0.50
-
0.50
1.00
Jan-
00
Jul-
00
Jan-
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Jul-
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06
Jul-
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25 del Model Value
25 del Price


GBPJPY

Like any other carry trades, GBPJPY risk reversals
are bid for downside with investors demanding
protection for long cash positions. The 1m risk
reversal is priced at -0.6 vols and the one year is -
0.72 vols. At these levels both the front end and back
end risk reversals seem overvalued with respect to
implied volatility.

Also, on average the risk reversal rarely pays for itself
in GBPJPY. We find that while there is a significant
negative relationship between implied volatility and
spot levels, there is no significant relationship
between the spot moves and the changes in the
realized volatility (from 2002- today, fig. 21). Naturally,
this results in the skew implied by the distribution
having a much more negative value than the actual
skew in the realized distribution.

Like other currency pairs analyzed before, spot
trends have definitely driven the risk reversal prices
in this currency pair as well. There was a big sell off
in GBPJPY spot in the year 2000 when GBPJPY went
from around 179 to 148.72 and since then there have
been several small sharp sell offs. We think that
these sharp crashes might cause a market crash
risk premium. For a certain amount of time, the risk
reversal more than pays for itself and after that the
risk premiums turn more negative and the risk
reversal becomes overvalued.

This dynamic leads us to suggest conditional variance
swaps or premium collecting trades for this currency
pair.

Fig 22. GBPJPY realized risk reversal has usually
exhibited a less negative skew than implied
Realized vs. Implied Risk reversal
-5.00
-4.00
-3.00
-2.00
-1.00
0.00
1.00
2.00
3.00
4.00
5.00
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Realized Riskie
Implied Risk Reversal

Fig 20. Back End GBPJPY risk reversals are over
valued with respect to implied volatility
-3.00
-2.00
-1.00
-
1.00
2.00
3.00
4.00
5.00
6.00
7.00
8.00
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Jan-
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Jul-
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Jan-
06
Jul-
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25 del Model Value
25 del Price

Fig 21. GBPJPY realized volatility shows no
relationship with spot moves in our sample
y = -0.0528x - 0.0784
R
2
= 0.0053
-6
-4
-2
0
2
4
6
-5.00 -3.00 -1.00 1.00 3.00 5.00
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Deutsche Bank@
11

AUDJPY

AUDJPY has consistently been one of the most
popular carry pairs due to the high Australian interest
rates (6.4%) and the low Japanese interest rates
(0.66%). With a history of frequent and sharp sell
offs, for example in 2000, AUDJPY went from around
71 to 55.99; this pair exhibits a significant skew- 1
month 25 risk reversal is valued at -0.95 vols and the
one year is -1.5 vols. It is also a reasonable argument
that this implied skew includes a crash premium.
At these levels the front end risk reversals are fairly
valued with respect to implied volatility but the back
end risk reversals are overvalued with respect to the
implied volatility.

As expected, the realized skew of the return
distribution is consistently less negative or less on an
absolute value basis than is implied by the value of
the risk reversal contract. This means that the risk
reversal is overvalued with respect to realized
volatility.

When we glance at the charts we notice that
AUDJPY follows the typical yen cross sell off pattern-
sell off happens, short and long end implied risk
reversals widen considerably, for a short period of
time front end risk reversal pays for itself and then
gradually it becomes more expensive, while the back
end risk reversal frequently doesnt pay for itself
(esp. if kept to maturity). We like buying 6 month
AUDJPY variance swaps at 7.8% while the regular
var swap is at 8.15%. In this case the fixings below
87 will not count towards the var swap calculation.

Fig 23. Naturally, AUDJPY has a negative
relationship between spot and implied volatility
y = -0.2357x + 0.0234
R
2
= 0.1622
-2
-2
-1
-1
0
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1
2
2
-3.00 -2.00 -1.00 0.00 1.00 2.00 3.00
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Fig 24. Front end AUDJPY risk reversals seem fairly
-5.00
-4.00
-3.00
-2.00
-1.00
-
1.00
2.00
3.00
Jan-
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25 del Model Value
25 del Price

Fig. 26. AUDJPY realized skew is consistently less
negative than the implied skew
-3.00
-2.00
-1.00
0.00
1.00
2.00
3.00
M
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Realized Riskie
Fig 25. Back End AUDJPY risk reversal has been
consistently overvalued according to the model
-5.00
-4.00
-3.00
-2.00
-1.00
-
1.00
2.00
3.00
Jan-
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25 del Model Value
25 del Price

AUDUSD

AUDUSD 1m risk reversal is -0.5 vol and the back
end is -0.57 vols. At these levels the front end risk
reversals are fairly valued with respect to implied
volatility while the longer dated risk reversal
contracts seem overvalued with respect to implied
volatility. The risk reversal is overvalued with respect
to realized volatility (fig 30) so we like collecting the
risk premium via instruments like conditional variance
swaps.

We see that spot and implied volatility have a slight
negative correlation. The spot trend and risk reversal
pricing dynamics work similar to other currency pairs.
We find that as AUDUSD rallied steadily from 0.63 to
0.80 from 2002 to 2003 risk reversals went bid for
AUD calls, reflecting a spot regime change. Again,
we notice that the implied distribution seems to
overestimate the skew present in the realized return
distribution.

Also, in keeping with the big spot move leading to
risk reversal overvaluation, we observe that the back
end risk reversal became overvalued with respect
to implied volatility after we saw a massive sell off in
AUDUSD spot in end of 2003 to the middle of 2004.

Fig 27. AUDUSD front end risk reversals seem fairly
-3.00
-2.50
-2.00
-1.50
-1.00
-0.50
-
0.50
1.00
1.50
2.00
2.50
Jan-
00
Jul-
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Jan-
01
Jul-
01
Jan-
02
Jul-
02
Jan-
03
Jul-
03
Jan-
04
Jul-
04
Jan-
05
Jul-
05
Jan-
06
Jul-
06
25 del Model Value
25 del Price
Fig 29. AUDUSD back end risk reversals seem over
-1.40
-1.20
-1.00
-0.80
-0.60
-0.40
-0.20
-
0.20
0.40
0.60
Jan-
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Jul-
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Jan-
01
Jul-
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Jan-
02
Jul-
02
Jan-
03
Jul-
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Jan-
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Jul-
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Jan-
05
Jul-
05
Jan-
06
Jul-
06
25 del Model Value
25 del Price

Fig. 30. AUDUSD realized risk reversal has been
consistently less negatively skewed than the implied
-2.00
-1.00
0.00
1.00
2.00
3.00
4.00
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Realized Riskie

Fig 28. AUDUSD spot and implied volatility have a
slightly negative correlation
y = -6.7021x - 0.0123
R
2
= 0.017
-3
-2
-1
0
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3
-0.10 -0.05 0.00 0.05 0.10
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Deutsche Bank@
13
USDCAD

USDCAD 1m risk reversal at 0.1 vol and 1y at 0.07
vol is fairly valued with respect to implied and
realized volatility. The spot and implied volatility have
a slight negative correlation which is not very stable
through time which means that the risk reversals flip
signs from positive to negative frequently.In general,
we observe that whenever spot is trading within a
range the front end risk reversals are usually fairly
priced, However, when spot breaks out of range
then the risk reversal contracts become bid in that
direction. For example if USDCAD rallies and breaks
the range then the risk reversal is bid for USD calls
and if USDCAD sells off and breaks the range then
CAD calls are more expensive.

Essentially the idea of the market over reaction
seems to be prevalent. However, for a short period
of time the risk reversals do pay for themselves as
for example in May 2002 the risk reversals more than
paid for themselves. However, in June 2003 the risk
reversals were overvalued in 2003 as USDCAD had a
sharp decline and the risk reversal went bid for CAD
puts. Like other currency pairs in USDCAD risk
reversal also, we find that it is easier to sell into the
rallies by using the model carefully to find a
persistent overvaluation the market.

This overvaluation seems to result from an
overestimation of the probability of the sharp spot
move continuing.

Fig 34. USDCAD spot and implied volatility have a
slightly negative correlation which is not very stable
y = -2.8797x + 0.0068
R
2
= 0.0127
-3
-2
-1
0
1
2
3
-0.10 -0.05 0.00 0.05 0.10
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Fig 31. USDCAD implied and realized skew are
usually close to each other and fairly valued
-1.50
-1.00
-0.50
0.00
0.50
1.00
1.50
F
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Fig 32. USDCAD front end risk reversals are faily
-1.50
-1.00
-0.50
-
0.50
1.00
1.50
Jan-
00
Jul-
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Jan-
01
Jul-
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25 del Model Value
25 del Price
Fig 33. USDCAD back end risk reversals are fairly
valued at the moment
-1.00
-0.80
-0.60
-0.40
-0.20
-
0.20
0.40
0.60
0.80
Jan-
00
Jul-
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Jan-
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Jul-
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06
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25 del Model Value
25 del Price

EURCHF

EURCHF implied volatility and spot show a slight
negative correlation and the 1m risk reversals are
priced at -0.05 vols which means that they are almost
flat (i.e. call and put have almost similar implied
volatilities). At this level the front end risk reversals
are fairly valued with respect to implied volatility (fig.
35). The flat level implies that the spot has not had a
massive trend so it is not a surprise that it is fair
value. However, the back end risk reversal at -0.125
vol is slightly overvalued (fig 37) and the actual skew
is consistently less on an absolute value basis than
what is implied by the distribution derived from the
risk reversal contract.

Again, we see that EURCHF spot shows the classic
sharp sell off and slower rallies up, which like the
previous currency pairs, means that the implied skew
is likely to be more negative and the longer term risk
reversals are more likely to be overvalued
Additionally, since in CHF crosses there is the belief
of CHF being a crisis currency, longer dated CHF
calls might be seen as providing insurance.

Fig 35. EURCHF front end risk reversals are fairly
valued at the moment
-3.00
-2.50
-2.00
-1.50
-1.00
-0.50
-
0.50
1.00
Jan-
00
Jul-
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Jan-
01
Jul-
01
Jan-
02
Jul-
02
Jan-
03
Jul-
03
Jan-
04
Jul-
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Jan-
05
Jul-
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Jan-
06
Jul-
06
25 del Model Value
25 del Price

Fig 38. EURCHF implied volatility and spot show a
slight negative correlation
y = -7.1506x - 0.01
R
2
= 0.0314
-2
-2
-1
-1
0
1
1
2
2
-0.05 -0.03 -0.01 0.01 0.03 0.0
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Fig 37. EURCHF back end risk reversal is over valued
according to the model
-2.00
-1.50
-1.00
-0.50
-
0.50
1.00
Jan-
00
Jul-
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Jan-
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Jul-
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Jul-
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Jan-
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Jul-
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Jan-
05
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06
Jul-
06
25 del Model Value
25 del Price

Fig 36. EURCHF realized skew is consistently less
negative than the implied skew
-2.00
-1.50
-1.00
-0.50
0.00
0.50
1.00
1.50
2.00
J
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-
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Realized Riskie

Deutsche Bank@
15
EURJPY

EURJPY has similar characteristics to USDJPY and
other yen crosses; essentially there is a stable
negative relationship between spot and implied
volatility. The front end risk reversal is overvalued
(fig. 39) with respect to implied volatility. Similarly,
the back end risk reversal is overvalued and we
notice that the skewness implied by the distribution
is more (on an absolute value basis) than what is
realized in actual returns.

The implied and realized skew become less negative
in the end of 2000 and beginning of 2001 as EURJPY
rallied sharply resulting in the implied and realized
skew changing across all models. Since then,
EURJPY has experienced a steady uptrend and
occasional sharp draw-downs. In 2003 EURJPY
experienced sharp down moves and naturally the
back end risk reversal in EURJPY suddenly became
overvalued after 2003 due to the insurance
premium attached to the possibility of another sharp
down move.

After the sharp down move it is also interesting how
even in the front end risk reversal the implied and
realized skew diverge due to the addition of the risk
premium. In our opinion it is these drawdowns that
provide a good trading opportunity, either via buying
the risk reversal or via conditional variance swaps.
These are reflected by our model - we see that the
model line is consistently closer to zero as compared
to the actual price of the risk reversal almost through
the life of the model (refer to chart).

Fig 41. EURJPY realized skew has been consistently
less negative than implied by the risk reversals
-5.00
-3.00
-1.00
1.00
3.00
5.00
J
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Fig 39. EURJPY front end risk reversal is overvalued
according to the model
-4.00
-3.00
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25 del Price

Fig 38. EURJPY has exhibited negative correlation of
spot and implied volatility from 2002- today
y = -0.111x - 0.0125
R
2
= 0.0954
-2.0
-1.5
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Fig 40. Back end EURJPY risk reversal has been
consistently overvalued wrt implied volatility
-2.50
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USDCHF

As a safe haven currency CHF, typically rallies in
times of crisis. Usually, in times of crisis implied
volatility shoots up also. Thus we find that USDCHF
spot and implied volatility have a stable negative
correlation.

The 1m (front end) risk reversal is bid 0.30 for USD
calls and we think they are overvalued (fig. 43) Once
again, this is a function of the market reasoning that
there will be a sharp dollar up move and as spot
breaks out of range the volatility will go bid. We
agree with the logic presented, but disagree with the
probability of the sharp dollar move. We think that
the probability of the sharp dollar move up is
considerably less than implied by the risk reversal
distribution.

The back end risk reversals have come in over the
last two weeks from -0.45 vols (bid for CHF puts) to
-0.23 for CHF puts which is much closer to fair value
with respect to implied volatility (fig 44).There is a
possible argument that they might have a risk
premium built in and hence might seem more
overvalued.

With the implied and realized skew of the front end
risk reversal close to zero , this risk reversal also
seems fairly valued with respect to realized volatility.
However when we examine the back end for implied
vs. realized skew, we find that the risk reversal is
overvalued with respect to realized volatility. Our
preferred trade in USDCHF would be to buy the back
end risk reversal in times of a crisis and collect the
crisis premium.

Fig 44. USDCHF back end risk reversal is slightly
overvalued
-2.00
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-1.00
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Fig 43. USDCHF front end risk reversal is overvalued
valued according to the model
-4.00
-3.00
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4.00
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Fig 45. USDCHF realized skew is close to the skew
implied from the risk reversals
-3.00
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Fig 42. USDCHF spot and implied volatility have a
stable negative correlation
y = -11.684x - 0.1076
R
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= 0.2375
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1 month change in USDCAD Spot
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Deutsche Bank@
17
Analysis of the risk reversal model

We observe a few systematic patterns from our
skew valuation models. Below we discuss and
summarize the observations of valuations with
respect to implied and realized volatility and also note
possible improvements to the model.

Observations about the risk reversal valuation
with respect to implied volatility

When spot is trading in a range, front end
risk reversals tend to be close to fair value
with respect to implied volatility as the
market seems quite good at pricing the risk
reversal with respect to implied volatility
during those times. We dont observe many
systematic trading opportunities, however
from time to time we find that risk reversals
become over or undervalued.
A sharp spot movement usually results in the
front end risk reversal paying for itself for
some time but then the market begins to
overestimate the volatility changes with
respect to spot movement. At that point we
find the front end risk reversal contract
becoming overvalued with respect to implied
volatility. These result in the most systematic
trading opportunities of selling the
overvalued risk reversal.
The effect of a sharp spot movement on
back end risk reversals is greater. The back
end risk reversals seem to have a higher
tendency to become overvalued with
respect to implied volatility and remain that
way for longer periods. It seems that the
market usually overestimates the
magnitude and the life of the trend and
prices in a regime shift The back end of
the risk reversal is usually slightly overvalued
according to the model. However, the back
end overvaluation could also reflect a term
structure of risk premium which is upward
sloping.
We find the overvaluation effects to be
exacerbated in case of carry currencies.
Usually, many market participants are
invested in the carry trade. These currency
pairs experience sharp declines and hence
these investors bid up the prices of the lower
interest rate currency calls as they all want to
buy protection. So after the carry currency
pair experiences a sharp sell off, the
investors attach a higher subjective
probability of a sell off happening again.

Observations about risk reversal valuation with
respect to realized volatility

We observe that the realized skew of the
return distribution is less on an absolute
value basis in most currency pairs than
implied by the risk reversal contracts.
We observe that the difference between the
realized and implied skew is more substantial
in the higher carry currencies. We think a
similar explanation of the crash risk
premium drives the difference in the
realized and implied skew.
In the event of a sharp spot movement the
realized skew exceeds the implied skew for
a certain period of time and the risk reversal
pays for itself. However, after the event
the implied skew continues to be higher and
the market overestimates the possibility of
the regime shift continuing and also
becomes more willing to pay the insurance
premium via the difference between the
implied and the realized skew.
A good (but rough) rule of thumb is that risk
reversals rarely pay for themselves when
they are above 0.5 vols.

Further improvements to the model

With our model, we are inherently subscribing to
some sort of a linear relationship between spot
and volatility which is closer to a Heston type
stochastic volatility model (although we allow for
the correlation to vary across time) than a local
volatility model. There is no theoretical reason at
all for the spot and volatility relationship to be
linear. However, given that we look at daily
changes and do separate the upmoves from the
down moves we have eliminated the first order
issues with assuming the relationship to be
linear. To be theoretically more correct we
should have a volatility and spot relation model
for every currency pair, which would then be
calibrated to fit the various market observed
option prices and end up as a time varying mix of
local and stochastic volatility model and we
would simulate the path taken by spot and then
estimate the returns of our investment strategies
to really capture the risk reversal value with
respect to both implied and realized volatility. All
this will naturally require considerable calibration
and computation. That seems impractical at this
stage.

Additionally, we still need to uncover the
macroeconomic or consumption based asset
price factor that underpins the purported risk
premium- remember that in any standard asset

pricing model such as the CAPM, the ICAPM or
APT, we need covariance with the consumption
portfolio (proxied by various factors usually).
The issue of the risk premium in currencies
remains a thorny one and as practitioners, we are
interested in the basic risk factors as long as
they either help us in hedging them or in terms
of any predictive or return explanatory powers.

However, there are other easier and more fruitful
improvements at hand. We could correct for
constant interest rate assumptions in our model.
We could also make some distributional
assumptions about the skewed currency pairs,
while computing the realized skew. Obviously,
any departure from normality costs computation
times and increases complexity.

Yet another application of the skew analysis
could be to use them in conjunction with the
carry trade(s) since they appear to be closely
related. It would also be interesting to extend
this analysis to emerging markets since the risk
factors there are more apparent.

On another front, we could develop a cross
sectional model that would enable us to compare
risk reversals across currency pairs and identify
common characteristics leading to risk reversal
portfolio opportunities or trading models. A cross
sectional model using a spot range breakout
indicator, interest rate differential, country default
probability and current account deficits might be
an interesting extension.

Currency Pair Risk Reversal*
EURUSD Overvalued
GBPUSD Overvalued
NZDUSD Undervalued
GBPJPY Overvalued
AUDJPY Fairly valued
AUDUSD Fairly valued
USDCAD Fairly valued
EURCHF Fairly valued
EURJPY Overvalued
USDCHF Overvalued
USDJPY Overvalued
Risk Reversal Summary Table

This has been prepared solely for informational purposes. It is not an offer,
recommendation or solicitation to buy or sell, nor is it an official confirmation
of terms. It is based on information generally available to the public from
sources believed to be reliable. No representation is made that it is accurate
or complete or that any returns indicated will be achieved. Changes to
assumptions may have a material impact on any returns detailed. Past
performance is not indicative of future returns. Price and availability are
subject to change without notice. Additional information is available upon
request.
Dedicated to Mom, Rachel and Manu
*1m risk reversal valued wrt implied vol

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