FxWirePro: Uphold costless EUR/SEK options combinations using AEDs

The FX option prices are not priced in the unambiguously positive asymmetry of Swedish Krona spot outcomes. Prices of at-expiry digital (AED) options would be construed as probabilities of spot ending at or beyond strike thresholds at maturity, and are useful for studying the option-implied likelihood of spot outcomes.

One side-effect of the correction in EURUSD has been that PLN and SEK, both of which we like, have fallen further against the dollar than the euro has. That’s not a new pattern and points to heavy positioning, as many people bought ‘euro-alternatives’ rather than the real thing, earlier this year.

The starkly positive asymmetry of SEK spot outcomes is not reflected in option prices. Prices of at-expiry digital (AED) options can be interpreted as probabilities of spot ending at or beyond strike thresholds at maturity, and are useful for studying the option-implied likelihood of spot outcomes.

SEK has long been tilted in favor of significant krona appreciation, albeit with uncertainty around timing given Riksbank's intransigence in adjusting ultra-loose monetary policy even in the face booming economic growth.

The above chart plots the implied distribution of EURSEK over 6-month and 1-year forward windows using EURSEK AED option prices for strikes of varying moneyness.

More than absolute probabilities of up or down moves that can be difficult to assess on a standalone basis, the standout feature of the plot is the lack of any discernible skewness in bullish and bearish outcomes; if anything, the RHS panel shows that strikes beyond ±2% from current market price EUR calls/SEK puts more expensively (i.e. more likely) than comparable % OTMS EUR puts/SEK calls, which militates against the balance of FX risks laid out above and is a textbook instance of disconnect between option market pricing and macro assessment of  the spot distribution.

We favor buying zero-cost combinations of long EUR put/SEK call vs. short EUR call/SEK put digitals to position for an eventual normalization of Riksbank policy; for instance, off spot ref. 9.5275, 6M 9.20 EUR put/SEK call vs. 9.80 EUR call/SEK put at-expiry digital risk-reversal has a net premium credit of 2.7% EUR (-5.2 /2.7 two-way indicative. assuming equal EUR notionals/leg). The short strike is above the YTD high, hence reasonable cushion against a backup in spot. Courtesy: JPM