…writes Eric Burroughs in his latest column. Take a look at his analysis of the Euro – Swiss Franc hedge:
(…) How do you hedge against the potential collapse of a single currency used in a $13 trillion economic zone plus trillions more of securities and derivatives? Not easily. A splintering or breakup of the euro has gone from unimaginable to a risk that can’t be ignored altogether. Europe’s inability to get ahead of the crisis now means a sovereign debt crisis is fast becoming a banking one. The solutions — a super sized EFSF rescue fund, Eurobonds, a commitment to fiscal union — are there to be had. But the political will is lacking.
Back to the hedging. The options market is the obvious place to turn, especially deep out-of-the-money options that typically mean you don’t have to pay a lot upfront to protect against a doomsday scenario. For the euro, this has been most apparent in the euro/Swiss franc FX options market where the hedging for downside protection against the euro has been intense. The extreme implied vol skew towards EUR/CHF puts reflects big demand for such protection. The Swiss franc is bearing the brunt of the selling not just because of the franc’s perceived safe-haven status, but also because Asian central bank diversification of dollar holdings has kept euro/dollar surprisingly high for all the single currency’s worries. (So in some ways, the Swiss National Bank can blame its counterparts in Asia for making the pressure on the franc so acute. ) The franc is the Alpine haven as the European project threatens to tear apart at the seems, and the SNB’s attempts to get extremely unconventional in fighting this battle — flooding liquidity and creating negative short-term interest rates — are only partially working. The below surface now shows more demand for short-term EUR/CHF calls in case the SNB succeeds, but the steep skew towards out-of-the-money puts is one of the best gauges for showing the extreme nervousness over what the endgame really is in Europe. When the skew starts to normalize, then the market may be convinced that Europe is getting a handle on this crisis. We are far from that point.
Felix Salmon interprets Burroughs:
(…) The chart is showing how expensive it is to buy options on the EUR/CHF exchange rate — that is, the number of Swiss francs per euro. When the Swiss franc strengthens, as it has been doing of late, the exchange rate goes down. The current exchange rate can be seen in the middle the “Delta” axis, where it says “ATM” — that stands for “at the money”. So everything to the left of that line — the PUT contracts — shows the price of a bet that the Swiss franc is going to strengthen. And everything to the right of the line — the CALL contracts — shows the price of a bet that the Swiss franc is going to weaken.
Now the Swiss franc has appreciated a lot against the euro of late — you could get more than 1.5 Swiss francs to the euro this time two years ago, while a couple of weeks ago the exchange rate dropped to as low as 1.03, and it’s still at 1.12 right now. To put it another way, a 100 Swiss franc meal in Zurich would have cost you €65 two years ago, €76 one year ago, and €89 today. At this point, the Swiss franc is so strong that the Swiss National Bank is doing everything in its power to try to weaken it. So the time to bet on a strengthening Swiss franc was clearly in the past.
But just look at the chart — it’s much higher on the left-hand side, the PUT side, than it is on the right-hand side. That’s known as “skew”, and it means that the market is decidedly bearish on EUR/CHF. If you want to bet that the exchange rate is going to go back up, that will cost you quite a lot of money. But if you want to bet that the exchange rate is going to continue to decline, that’s going to cost you an absolute fortune.
And in fact the market seems to think that even if the Swiss National Bank manages to weaken the Swiss franc in the short term, over the long term its efforts won’t count for much. The lowest parts of the chart — the cheapest bets of all — are the ones saying that the Swiss franc is going to weaken over the long term of 18 months to 2 years. Meanwhile, the highest parts of the chart — the most expensive bets you can make — are the ones saying that the Swiss franc is going to strengthen a lot over the long term of 18 months to 2 years.
(…) But the main message of the chart is that people are almost irrationally worried right now. The Swiss franc is a classic flight-to-safety play, a bit like gold or Treasury bills. (…)