FX Quant Strategy provides a quantitative overview of the currency market, including several valuation tools and monitors, focusing on the FX options market.
This week we recommend two FX option trades:
- Enter bullish 3M USD/JPY risk reversal
- Enter bullish 3M USD/CAD ratioed seagull
Short-dated implied FX volatility has generally increased as March's series of major central bank meetings are moving closer. In particular, implied volatility on EUR and JPY crosses look expensive with 2W EUR/JPY at-the-money volatility being most expensive, which seems fair given the expectations of additional ECB and Bank of Japan (BoJ) easing. Moreover, 3-12M tenors generally continue to look expensive across majors and scandi crosses. Especially GBP volatility with maturities beyond the EU referendum on 23 June are very expensive according to our model, due to the 'Brexit' risk premium.
According to our spot monitor, we currently observe the strongest signal in USD/CAD, which both technically and according to our short-term financial model is oversold. In addition, implied volatility is expensive from three months and beyond. Following the recent rebound in the oil price, we see some upside risk to USD/CAD in the short run, therefore, we recommend to position for a possible rebound in the cross via a 3M bullish 2:1:1 ratioed seagull, which benefits from the expensive implied volatility.
In terms of option skews, we currently observe the most stretched valuations in USD/JPY in the 0-3M segment with 25 delta risk reversals being very cheap both in absolute terms and on a volatility-adjusted basis. From a risk/reward perspective, we think the very negative USD/JPY risk reversal offers good value and we like being long 3M risk reversal going into the BoJ meeting on 15 March, as we expect it to cut interest rates by 20bp to -0.3%. As such, the impact on USD/JPY of a rate cut further into negative terrain might be relatively limited compared with previous BoJ easing announcements, as the cross remains fundamentally undervalued. However, we would expect the cross to rally and subsequently stabilise at higher levels (sub 120 though) supported by relative rates.
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