Fondo 25Delta

FX Risk Premia in an inflationary world

Risk Premia in FX volatility markets usually refers to the difference between imply and realised volatility.

Academic studies have proven that the premium exists mostly between G4 currency pairs, and it is clearer the shorter the maturity is. The most evidence that produce the risk premia: investors and corporates feeling of risk being greater than what usually ends to be. They pay more for protection due to this belief. They pay more imply vol.

Volatility risk premia is seen in markets with different volatility regimes (high, low, medium), but can also be inexistent in specific market environments. This year was one of those environments.

High inflation, and the response of the Central Banks to hold it, have been the two major drivers of volatility this year. A fight against inflation not seen since the 80´s, with the FED applying the most aggressive hiking in any tightening cycle in memory. The FX markets were at the centre of repricing inflation risk premium higher, with the USD as the main catalyst. This has been the cause for FX volatility (together with fixed income´s) to outperform in sigma moves the volatility of equity, credit, and commodities markets, after years of underperforming.

Most currencies had a move greater than one sigma, and some of them even more than two…vols have more than doubled in the last year, yet in the top range but off the highs.

Interestingly also, risk premia have been inexistant for every currency pair in the G10 space, with realized vols being higher than the imply vols by as much as -7% in GBPUSD, and even close to -3% in the EURUSD.

Given than our fund’s strategies try to exploit the risk premia, how did we manage to extract value, or not being washed out of the market in most of the months since our launch on May 6th? Risk Management is the answer. Each of the strategies we design have embedded a risk control strategy with different layers. This approach managed to get positive, small negatives o cero results, every month except for June, a month to forgot by markets by the extraordinary moves it registered (even by the then highly volatile environment standards). Nervousness by central banks (ECB &FEC) in delivering or even forming a clear message was a key element to the results across all asset classes.

As we enter 2023, we expect the inflation driven volatility to transit to a more known by markets growth driven volatility, once the terminal rate by the FED is achieved and more information about the size of the slowdown, and how quick is the FED in relaxing their monetary policy is gathered.

We expect this to happen towards the middle of the year, and since then we expect an elevated volatility environment, with risk premia slowly to beginning to appear again, as the effects of tightening start to deliver results on inflation contention.