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FxWirePro: Spotlight On Implied Vs Realized Spot/Vol Correl For G10 FX-Bloc

For two USD/ccy pairs, one can simply compare the level of implied correlation (for simplicity, by referring to the ATM levels as discussed above) with the relative sign of USD riskies. On the occasions where the pricing of the two USD riskies is opposite, and the implied correlation is positive (or the other way around), there is an apparent mismatch as far as directionality of risk is concerned between riskies and correls.

The apparent conundrum can be resolved by realizing that, while implied correls for two pairs tend to be positive when measured via the common currency, and are therefore representative of a general appreciation or drop of that currency, the implied move as forecast by riskies sign could be better representative of the actual correlation in the left-tail, risk-off quadrant, with higher market vols.

Given that most USD correlations are positive and that the two pairs with risk-off sensitivity vs. USD are JPY and CHF, such RV opportunities can be currently found on triplets involving USD and just one of the two latter currencies (refer 1st chart).

When finding such RV mismatches, one could conclude that either the price of riskies or that of correls presents an opportunity. In this piece, we’ll assume that price of riskies correctly predicts spot directionality in a risk-off market, and we trade correlations accordingly, via dual-digital structures (conversely, one could be interested in trading riskies).

We keep in mind the strike sensitivity of correlation surfaces as seen above, which guides in the choice of the strikes for the dual digis for maximizing correlation discounts.

For instance, last week when suggesting bearish structures on EUR and GBP, we favoured closer to the money strikes on USDJPY, implying higher premia but better entry points in terms of higher implied correlation (refer 2nd chart). CHF/ccy USD-implied correlations are positive at present.

We point out that SNB intervention, as carried out last week, might put a cap on the possible appreciation of CHF. SEK looks appealing to be included into the structure on the back of a lower vol/less explosive price action so far displayed than for other G10 pairs (most notably, NOK) and an attractive entry point in terms of implied correl (around 47% for 3M USDCHF vs USDSEK correl, from ATM vols, trailing realized by just 15 corr points). The better risk tone over the past day, with lower vols and a weaker dollar, might offer a better entry point for playing the defensive structure as above. We point out that, while we do not cover XAU and XAG in the RV screener above, the positive sign of the XAUUSD RR would suggest value in considering XAU on par with JPY and CHF for offering correlation discount in dual-digital structures. 

The two dual-digi structures as recommended below summarize the earlier findings on attractive high-leverage structures respectively long and short correl. 

Consider:

Buy a 2M dual-digi (GBPUSD < 4% OTMS, AUDUSD < 4% OTMS) @ 14% (mid trades at 50% discount vs. cheapest digital) 

Buy a 2M dual-digi (USDCHF < 1% OTMS, USDSEK > 5% OTMS) @ 6.25% (mid trades at 80% discount vs. cheapest digital) 

Buy a 6M dual-digi (XAUUSD > 5%, EURUSD < ATMS) @ 15 % USD (mid trades at 60% discount vs. cheapest digital). Courtesy: JPM

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