FxWirePro: Dual risk aversion scenarios amid divergence between 3m EUR/USD and USD/CHF volatilities

This write up is articulated with a view to intend to prefer volatility spread due to the divergence offered by two G10 currency pairs (i.e. EURUSD & USDCHF) post-Brexit referendum.

An expensive and asymmetric spread EUR/USD 3m vol is trading about one volatility point above USD/CHF 3m vol (see above diagram), the widest spread since 2011. This expensive market pricing is not sustainable.

The spread widened post the UK vote, as EUR/USD moved more than USD/CHF. Both vols subsequently fell, but the spread is still elevated, which seems an inconsistency.

The implied vol spread surged in following the spike in the realised volatility spread (see above diagram).

While the 3m realised vol spread is elevated, it is not as high as it was last year when it spent some time above 1 vol, while the implied spread remained capped below 0.5 vols.

USD/CHF volatility can be seen as EUR/USD volatility with a tilt of CHF risk. Unlike the other two, EUR/CHF volatility usually trades at a large premium above its realised volatility, but this premium recently contracted, suggesting that CHF risk has become surprisingly cheaper.

The adjustment would lift USD/CHF volatility higher. With its relative value profile, the EUR/USD vs USD/CHF vol spread is asymmetric and is likely to perform in various market scenarios.

In more risk aversion scenario: It should support both vols, but the spread is already extreme and the CHF should outperform as a safe-haven currency.

During less risk aversion scenario: It should continue to pressure both vols, with EUR/USD catching up with the already-lower USD/CHF volatility, as CHF risk would stay contained.