Forex options traders count the cost of stressed VAR

Stressed value-at-risk has been less controversial than the other capital charges introduced in response to the financial crisis – but some dealers say the new metric is decreasing appetite for risk in foreign exchange options markets and might drive up costs for more exotic structures. Mark Pengelly reports

Foreign exchange options can no longer escape the past. Under old trading book rules, capital was calculated using the standard value-at-risk approach, in which periods of currency volatility would rapidly fall out of the historical data used to estimate worst-case losses. That changes under Basel 2.5, which uses a stressed VAR measure to generate an additional capital charge based on a period of historic market turmoil. Users of emerging market forex options – and more exotic products – could face a hike in costs as a result, dealers warn.

“There should be a market impact from stressed VAR, and it will start filtering through as more and more people realise stressed VAR is not benign. It will have an impact on their assumptions and I believe it will have a market impact, but the reality is that so far, a lot of banks haven’t paid much attention to it,” says Vincent Craignou, global head of forex and precious metals derivatives at HSBC in London.

Stressed VAR uses the same 10-day holding period and 99% confidence interval employed by the traditional VAR charge, but requires banks to estimate their losses using a one-year historical period of significant financial stress. This means finding a stressed period that is applicable to the bank’s entire trading book, say dealers – and most probably, one that covers the aftermath of the bankruptcy of Lehman Brothers in September 2008.

“The difference between Basel II and Basel 2.5 is that stressed VAR is added on top of the standard market risk VAR charge and it is the sum of the two that is used to dictate the overall capital. It basically means that 2008 is included in the computation of our capital charge – in other words, a bunch of scenarios where volatilities were much higher and currencies were moving all over the place,” says Gian-Luca Fetta, global head of foreign exchange at Société Générale Corporate & Investment Banking (SG CIB) in London.

As an example, three-month historical volatility in the US dollar/Brazilian real currency pair hit a massive 57.04% on December 12, 2008 (see figure 1). In contrast, three-month historical volatility in US dollar/Brazilian real was just 12.27% on August 20 this year, according to Bloomberg. That is a key cross for corporates and financial institutions with Brazilian businesses and real-denominated assets, where options-based hedging can take place in large size (Risk December 2011, pages 16–20).

There should be a market impact from stressed VAR, and it will start filtering through as more and more people realise stressed VAR is not benign

Similarly, on January 2, 2008, three-month historical volatility in US dollar/Korean won reached 50.94%. On August 20, it stood at 7.02%, according to Bloomberg.

In the depths of the crisis, volatility in euro/Swiss franc also saw a huge upswing as carry trades in the Swiss currency were unwound. By January 5, 2009, three-month historical volatility in the currency pair reached 14.82%. It has breached those levels during the eurozone sovereign debt crisis, but has since sunk back to 1.44%, according to Bloomberg. In large part, that’s because the Swiss central bank imposed a floor against the euro in September 2011.

In fact, options written on any currency that experienced severe volatility during the crisis will now attract capital levels that are too high, dealers argue – and in cases such as the Swiss franc, where there has been a fundamental change in the volatility regime, using data from the crisis can appear nonsensical. “Today, a deeply out-of-the-money option on, say, euro/Swiss franc may not add a large amount of risk. But the fact you have to compute these kinds of very extreme scenarios, like 2008, means the capital consumption for this kind of position is much increased, because of scenarios that happened in a very different market context,” says Fetta.

He estimates stressed VAR can increase the capital required against forex options positions by three to eight times, depending on the tenor of the trade, the strike of the option and the volatility of the underlying. The longer-dated the trade, and the more volatile the currencies, the greater the chance of the option seller having to pay out. That means shorter-term transactions in Group of 10 currencies will typically face a smaller capital hike, with longer-dated trades in less-liquid emerging market currencies at the other end of the spectrum. “We took various option positions and looked at at-the-money strikes, 25-delta strikes and 10-delta strikes for maturities over a reasonable time frame on different currency pairs. In terms of the capital increase under Basel 2.5, we found a multiplication by eight was the worst factor. A standard options book would probably be in the region of four,” Fetta says.

Whether this feeds through into options premiums and liquidity is another question. The risk of vanilla out-of-the-money options can be speedily laid off in the broker market, minimising the effect on pricing for clients, dealers say. According to Fetta, the first impact of the stressed VAR charge is likely to be an increase in the turnover of warehoused positions. “The fact the capital attached to outright risk is increasing will naturally lead banks to warehouse less forex risk. The first consequence is that it will increase the turnover of positions in the trading book,” he says.

In more exotic foreign exchange options trades, the impact could be more pronounced, says HSBC’s Craignou. “It’s quite clear that when you look at the stressed scenarios, stressed VAR can potentially have a big impact against the positions you run. For this reason, we took the charges very seriously and we started analysing them,” he says. This analysis has been helped by the introduction of a new electronic tool that HSBC’s traders can use to quantify the marginal increase in risk-weighted assets (RWAs) on new trades – RWAs are the foundation for bank capital calculations.

Craignou says trades with a high degree of convexity – those that are most sensitive to volatility in the underlying currency, in other words – will be among the worst hit. These include double no-touch (DNT) options, which pay out as long as the underlying stays within a band set by two different strikes. When dealers sell DNTs to clients, they typically hedge the trade by buying and selling vanilla options. However, those positions must be rebalanced constantly as the underlying spot rate changes. Dealers say the rocky markets simulated by stressed VAR would make the sale of DNTs and the related hedging activity look onerous from a capital perspective.

An accurate and reliable price history for DNTs is hard to obtain due to the market’s poor liquidity. Nonetheless, Craignou thinks the products have become more expensive since the end of 2011 – and suspects stressed VAR might be to blame. “If you sell DNTs to clients in emerging market currencies, you need to hedge them, and this activity can have a pretty big impact on stressed VAR,” he says.

Trying to prove that contention is difficult, though. Rather than analysing prices for DNTs traded in the market, Craignou looked at the ratio of 10-delta butterfly spreads to 25-delta butterfly spreads – a good indicator of the cost of convexity, which is a key driver of the price of DNTs. The analysis found there had been an uptick in the cost of convexity for various currency pairs, including US dollar/Brazilian real, US dollar/Korean won and US dollar/Mexican peso since the introduction of Basel 2.5 at the end of 2011. “There was definitely a kick in convexity pricing last year and it was definitely sustained in some currencies. However, you can’t say this is all due to stressed VAR. What you can say is the convexity pricing in emerging market currencies has got more expensive and that stressed VAR could have played a role,” says Craignou. Indeed, the uptick may have reflected the tricky market conditions seen in late 2011 and early 2012, he adds.

Other dealers point to different reasons for increasing DNT costs. Nilton David, New York-based global head of forex correlations and Latin American currencies at Citi, says higher implied volatility at out-of-the-money strikes is typical as overall volatility levels come down. “Maybe compared with recent history, there is an impression that convexity is expensive, but it’s natural. As at-the-money volatility comes down, the wings take a little longer to flatten out. The market is pricing in an expectation of trading within a range – and that is exactly what it is doing at the moment,” he says.

Some participants point out that banks have become increasingly risk-averse over recent years – and this effect is not specific to DNTs. “While increasing cost of capital is a small factor having an impact on the ability of banks to warehouse risk in foreign exchange, increasing institutional risk aversion still accounts for the majority of the market retrenchment over the past few years,” says Simon Manwaring, London-based head of forex options at Santander.

Whether or not the effects are currently being felt in the market, Craignou at HSBC argues the impact will gradually filter down to clients. “If you sell $100 million of vanilla options, that could potentially be quite penal from a stressed VAR point of view, but you have the ability to buy the risk back in the market quite easily, so you can mitigate the stressed VAR impact. But the capital charge for DNTs is also quite painful – and on them, there is no market supply,” he says.

Dealers could respond by hiking prices for trades such as DNTs, or trying to find other ways of hedging them effectively. SG CIB’s Fetta believes the challenge for dealers will be attempting to find new hedging methods and distribution channels to offload the risk of these products. “In general, you could say all the exotic products would be penalised in terms of capital consumption – and all the more so if you don’t have a culture of offloading the risk. This is going to show the difference between houses that have developed an exotic risk transfer approach, like us, versus firms where there is more a culture of warehousing risk,” he says.

If stressed VAR does make some foreign exchange trades more expensive, it could be seen as another case of collateral damage in post-crisis regulation, says Christopher Finger, executive director at risk vendor MSCI in Geneva.

“This could well be an unintended consequence of stressed VAR. These regulations were made with fixed income, credit and structured credit at the top of regulators’ minds. I don’t think anybody was worried about forex derivatives positions becoming a source of blow-ups, so I’m not sure it was intended to penalise them that much,” he says.

And if the impact of the charge becomes noticeable, US dealers may stand to profit. Basel 2.5 is not due to be implemented in the US until January 2013 – a full year after banks in the European Union. In some areas, such as credit, European banks have claimed this implementation gap has given their US counterparts a competitive advantage, allowing them to wind down capital-intensive positions more slowly (Risk January 2012, pages 80–83). If stressed VAR drives up the cost of trading with European banks but not US ones, European dealers say they could also be disadvantaged in the forex market – even if only temporarily.

 

BOX: The future of stressed VAR and Basel 2.5

Despite the fears of foreign exchange options traders, stressed value-at-risk remains less controversial than other aspects of Basel 2.5, such as the incremental risk charge (IRC) and the comprehensive risk measure (CRM). These two charges take sniper-like aim at specific risks or products – credit risk in the case of the IRC and correlation trading for the CRM – which means they have a big impact on risk-weighted asset (RWA) numbers for certain businesses (Risk July 2012, pages 16–20).

“In our experience, interest rates and credit are much worse hit by the trading book charges. They both entail a big consumption of Basel 2.5 RWAs – and that’s mainly related to the IRC charge, which can be very substantial,” says Marc van Balen, global head of trading risk management and product control at ING in Amsterdam.

Stressed VAR, in comparison, is a regulatory blunderbuss, hitting every trading position – but potentially not doing a huge amount of damage. Because it is calculated across the entire trading book and reflects the risk of all those positions during a period of stress, losses on long positions will be offset by gains on short positions.

But by tying capital requirements to periods of past market turmoil, stressed VAR still has the potential to sting in places, says one London-based head of market risk at a major dealer. “Because stressed VAR has a long memory, if there’s a very special event in a very special market segment, then potentially that market segment will become expensive forever. You could have instances where the world for a particular instrument has completely changed and history has no bearing on what the future will look like,” he says.

Regulators may not be persuaded by those arguments, of course, and even the market risk head concedes it has become difficult to claim that lightning could not possibly strike in the same place twice. ”Can you put your hand on your heart and say the market will never experience the same stress again? The answer is absolutely not.”

That does not mean stressed VAR and the other Basel 2.5 charges are here to stay. In May, the Basel Committee on Banking Supervision launched a fundamental review of trading book rules – three years after Basel 2.5 was finalised and less than six months after their introduction. The review seeks to improve the coherence of the various Basel 2.5 charges, meaning there could be major modifications to stressed VAR, or even a wholesale scrapping of the charge. Among the other topics being discussed is the need to improve the way liquidity is reflected within Basel 2.5 – a discussion banks hope will benefit more liquid products, such as forex derivatives – but regulators have warned that implementation of any changes is a long way off.