Volatility trends: What can you do to reduce currency risk in 2023?
Currency traded volatility can be caused by a variety of factors, including economic data releases, political events, central bank actions and geopolitical risks. In 2022 we experienced many of these factors, making the value of currencies rise or fall in relation to others. For example, volatility traded significantly higher last year as the USD strengthened and central banks tightened monetary policy.
The table below shows the market traded volatility levels and their changes over the past year. The second column lists the 3-month market traded volatility (implied) which is the most common refence point. Volatility levels are higher in all cases with the largest increase (7.9%) and the highest absolute level (14.4%) in USD/JPY. This is potentially not surprising given the spot market movement in this currency.
The fourth column shows the market levels on the risk reversals (the price of the call volatility above the put volatility). What is normally observed in times of high volatility is a pronounced risk reversal meaning that if the market moves in the risk direction, the spot movement will accelerate. The situation in the option market at present is that there is no such extreme bias meaning volatility is high without specifying a direction.
The charts below for each currency pair show the 3-month market traded volatility (implied volatility) in white over the past 5 years with the corresponding spot chart below it in yellow. What we can see is that in all currency pairs implied volatility is trading above the average.
The second chart for each pair plots the same 3-month implied volatility over the last year in white vs the realized volatility (red). The realized volatility calculates the volatility based on the previous three months daily spot movement. In all cases the realized volatility is higher than the implied volatility suggesting that the implied volatility will stay strong.
The chart data is summarized in the following table:
USD/JPY 3-month implied volatility (white) and the spot(yellow). The current level of 14.4 % exceeds the average over the past 5 years of 7.6%
USD/JPY 3-month implied volatility (white) and realized volatility (red). The realized volatility is above the implied / market traded (17.4% vs 14.4%)
EUR/USD 3-month implied volatility (white) and the spot(yellow). The current level of 8.4% exceeds the average over the past 5 years of 6.9%
EUR/USD 3-month implied volatility (white) and realized volatility (red). The realized volatility is above the implied / market traded(10.9% vs 8.4%)
AUD/USD 3-month implied volatility (white) and the spot(yellow). The current level of 12.8% exceeds the average over the past 5 years of 9.6%
AUD/USD 3-month implied volatility (white) and realized volatility (red). The realized volatility is above the implied / market traded(15.9% vs 12.8%)
GBP/USD 3-month implied volatility (white) and the spot(yellow). The current level of 10.5% exceeds the average over the past 5 yearsof 9.2%. This is despite some uncertainty with Brexit trade negotiations.
GBP/USD 3-month implied volatility (white) and realized volatility (red). The realized volatility is above the implied / market traded(15.0% vs 10.4%).
USD/CAD 3-month implied volatility (white) and the spot (yellow). The current level of 7.8% exceeds the average over the past 5 years of 6.8%.
USD/CAD 3-month implied volatility (white) and realized volatility (red). The realized volatility is above the implied / market traded (9.3% vs 7.8%).
We expect volatility to remain at elevated levels compared to longer term averages due to the current SPOT market movement and the potential for further global shocks. In this time of uncertainty, it is good practice for corporate treasurers to have hedging in place to manage risk from fluctuations in exchange rates.
One effective strategy is to use hedging tools, such as forwards, options, or swaps, to lock in a specific exchange rate for a future transaction. This can help mitigate the impact of currency fluctuations on a company’s financial performance.
Another approach is to closely monitor currency markets and adjust business strategies accordingly. This can include adjusting pricing, sourcing, and production strategies, or shifting the focus of business operations.
Finally, it is important to have a strong risk management framework in place. This can include regular review and analysis of currency exposures, setting limits on exposure, and having a contingency plan in place.
By taking a proactive approach to managing currency risk, businesses can be better prepared to navigate the volatility trends in 2023.
