| HONG KONG
HONG KONG Switzerland's central bank may be using currency options to reinforce its target of capping the franc at 1.20 per euro in what would mark an unusually aggressive step that carries considerable risk.
The Swiss National Bank may be selling options -- in essence selling implied volatility -- to help reinforce the 1.20 line in the sand set this week in a shock move to stop further franc gains, according to about 10 option traders at major banks in Asia and Europe.
Using derivatives would allow the central bank to leverage its balance sheet and give itself more firepower, underlining its pledge to use "unlimited quantities" of intervention to maintain the 1.20 level.
One trader said the SNB appears to be selling volatility through a forward volatility agreement, which allows the central bank to sell volatility, or vols, without specifying a strike price -- such as 1.20 -- in addition to selling basic options via one or more of the big Swiss banks.
The SNB has resorted to some of the most extreme tools available to a central bank -- negative interest rates and now the potentially unlimited use of its franc printing press -- in its aggressive effort to stem the franc's damaging surge on the Swiss economy. The SNB declined to comment.
The franc has borne much of the pressure from market players reducing their exposure to the euro zone's debt crisis and seeking safety in the Alpine nation's economy, leading the currency to be massively over valued by most measures.
Acting directly in the currency options market could achieve two goals for the SNB.
By selling options, the SNB makes money if volatility stays low -- money that can help offset the cost incurred from any euro-buying intervention needed to maintain the 1.20 limit if the single currency comes under further pressure.
Selling volatility also means that the SNB has forced the euro/Swiss franc options market to turn suddenly long gamma, so that the hedging of option dealers would help dampen the daily moves in the currency pair. The opposite happens when the options market is short gamma, exacerbating sharp market swings.
DIPPING INTO DERIVATIVES
When central banks intervene in currency markets, they do so in the regular cash, or spot, market by selling or buying in big amounts.
Due to the risks involved with over-the-counter derivatives, from leveraged positions they create to the credit risk of engaging in bilateral contracts with banks, central banks tend to stick to the cash markets.
Using options also means that the central bank is exposed in both the spot and options markets if the franc strengthens sharply through 1.20 per euro.
The SNB's actions mean it is taking a big gamble that European policymakers will succeed in coming up with a solution to the debt crisis that will help the euro and take some of the pressure off the franc.
Since the 1.20 floor was announced and the franc vaulted nearly 10 percent to sit just above that level, implied vols in EUR/CHF have plunged from record highs.
Traders and analysts said it was unclear what were the main factors driving the sharp drop in implied vols across different strike prices: both the franc's sharp rebound and market players selling implied vol would lead to that outcome and reinforce each other.
Hedge funds and other market players likely rushed to sell options and volatility as well on the SNB's move to set the 1.20 floor, which would also generate gamma for options dealers.
WATCH THE RISKIES
One of the most closely watched FX option market gauges is the risk reversal, which shows how much market positioning is leaning in a particular direction.
Risk reversals reflect the extent to which players are leaning more toward call options (the right to buy spot) versus put options (the right to sell spot).
The extremes reached in EUR/CHF risk reversals rivaled anything seen in recent history, even during the 2007-08 financial crisis.
Before the Swiss central bank stepped in to institute the EUR/CHF floor, one-week implied vols were trading above 30 percent -- implying a huge move of 400 pips in the pair in a week was needed to make money on such a position. Indeed, just last week, the EUR/CHF range was a massive 1,000 pips.
The huge skew in the EUR/CHF implied vols toward puts showed the market bracing against further volatility and downside, even some long-term hedging against the risk of the 12-year-old single currency breaking up altogether.
The imposition of a 1.20 floor has arrested the violent volatility for now.
The market talk is that a lot of 1.20 strikes have been sold, which would increase the stickiness of the spot EUR/CHF rate around that level, traders and analysts said.
Double-no-touch options with downside barriers at 1.18/1.19 have also been cited that would do the same and would serve to help the SNB.
Robert Ryan, an FX analyst at BNP Paribas in Singapore, said that even with the sharp drop in short-term implied volatility from near 30 percent to near 6 percent, there was still more room for a slide to around 4-5 percent if the SNB succeeds a maintaining the spot rate close to the 1.20 floor.
But longer-term volatility would likely stay higher as the market braces for the potential that the euro zone crisis worsens and the SNB is forced to abandon its latest effort to stop the franc's rise, which could lead to an even more violent lurch lower.
If short-term volatility starts to rise again, it would be a sign the market is losing confidence in the SNB's ability to win this currency war.
"The steepness of the curve is going to be essentially a vote of confidence in the SNB," Ryan said.
(Additional reporting by Hideyuki Sano in Tokyo, IFR Markets, Masayuki Kitano and FX analyst Rick Lloyd in Singapore)