Stressed VAR will hit forex options, dealers warn

Basel trading book capital rules are having a punitive impact on certain foreign exchange options and may push up the cost of more exotic trades – particularly in emerging market currencies, dealers say.

The root of the issue is the regulatory capital charge for stressed value-at-risk, introduced for many banks as part of the Basel 2.5 package of reforms at the beginning of the year.

“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 market risk VAR charge, but requires banks to estimate their losses using a 12-month 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 includes the aftermath of the Lehman Brothers bankruptcy in September 2008.

Harking back to 2008 and 2009 will mean including some exceptionally turbulent times for currency markets. As one example, three-year historical volatility in the US dollar/Brazilian real cross hit 57.04% on December 12, 2008. In contrast, volatility in the pair was just 12.27% on August 20 this year, according to Bloomberg.

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

Dealers complain that using this data will make some forex options positions look riskier than they really are. According to Gian-Luca Fetta, global head of foreign exchange at Société Générale Corporate and Investment Banking in London, stressed VAR can increase the capital required against forex options positions by three to eight times. The exact increase depends on the tenor 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. Shorter-term trades in Group of 10 currencies will typically face a smaller capital hike, he says, with longer-dated trades in less-liquid emerging market currencies generally 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.

This effect could filter through to the exotic options market, where trades with a high degree of convexity would be hardest hit, dealers warn – one example is double no-touches (DNTs), 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 relative to the two strike prices. 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.

HSBC's Craignou says the price of DNTs in some emerging market currencies has already become more expensive since the beginning of the year – and suspects stressed VAR could be to blame. He 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. From the introduction of Basel 2.5 at the end of 2011, HSBC's analysis found there was 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, Craignou says. “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.

The stressed VAR charge was introduced alongside a set of other measures, including an incremental risk charge for default and credit migration risk, a standardised charge for securitisations and re-securitisations and a comprehensive risk measure for correlation trading books. While much of the focus has so far been on these other aspects of Basel 2.5, Craignou predicts the impact of stressed VAR will attract more attention over time.

Foreign exchange options are an unlikely source of bank blow-ups, dealers argue – leading some market observers to argue any impact on the products would be an unintended consequence of the new rules. On the other hand, stressed VAR is designed to broadly penalise asset classes and trades that suffered heavily during the last crisis – and from this perspective, there is little to complain about, says one London-based risk manager.

“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. ”But can you put your hand on your heart and say the market will never experience the same stress again? Absolutely not.”

The September issue of Risk looks in more depth at the impact of stressed VAR on forex options – articles will be available online next week.