Posted by Scriptaty | 5:26 AM

If exchange rates were nothing more than short-term interest rate arbitrage, we would have to conclude the USD should be much stronger than it is. Is this conclusion supported by the options market? The implied volatility of a currency forward represents the market’s assessment of future uncertainty and the willingness to pay insurance against this uncertainty.

The three-month volatility of USD forwards for a EUR-domiciled buyer generally falls as the EUR strengthens. The average lead time is 13 weeks, or one quarter. The most recent data shows volatility rising as the EUR rallies, which indicates those going long the EUR are also buying USD option protection. This is a market uncomfortable with its own trend.

The JPY exhibits a different relationship. The three-month volatility for a JPY forward for a USD domiciled buyer falls as the JPY strengthens. The average lead time here is 23 weeks, or nearly six months. The most recent data shows volatility rising, which indicates an increased demand for protection by USD holders against a stronger JPY. Unlike the case of the EUR, the JPY market appears quite comfortable with the notion of a stronger JPY.