FX Option Skews

Economics and implications

Erik Norland, Senior Economist, CME Group

Nearly all options markets exhibit some kind of natural skewness. For example, out-of-the-money (OTM) put options on equity index futures are typically more expensive than OTM call options: investors typically fear a sudden fall in stock prices more than a sudden rise and, hence, are willing to pay more for downside than upside protection. In agricultural markets, skew tends to work the opposite way. On corn, soy and wheat options, for example, OTM call options are usually more expensive than OTM puts. Food buyers fear a sudden spike in the price of these crops in the event of a bad harvest more than farmers fear a sudden price decline in the event of an exceptionally good harvest.

Currency options markets are quirkier than either equity or agricultural options markets. Generally, traders fear a sudden drop in most currencies versus the US dollar (USD) more than a sudden rise. Among the major currencies, the euro, pound and Australian and Canadian dollars tend to skew negatively versus USD, meaning that OTM put options tend to be more expensive than OTM calls. The Japanese yen and Swiss franc tend to have the opposite skew. Yen and franc OTM call options are often more expensive than OTM puts. For all six currencies, the degree of skewness varies over time, driven to a large extent by two factors: interest rate differentials and political risks. 

This paper also addresses another question: is option skewness (also referred to as “risk reversal”) a useful indicator of whether a currency will strengthen or weaken versus USD? For example, if OTM put options become extremely expensive with respect to OTM call options, is that a sign that a given currency is likely to crash versus USD or that the currency might be oversold and is about to rebound? Our analysis doesn’t provide a definitive answer to these questions but might nevertheless offer some useful insights.

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