I’m reading one of Kathy Lien’s books on currencies and she’s talking about risk reversals to gauge market sentiment, stating that OTM puts and calls should theoretically have the same IV but when they don’t, it reflects market sentiment. She then says that most pairs are generally neutral but one example that shows a definite bias is usd/jpy. Specifically she says (at the time of writing) yen calls and dollar puts were being favored and this reflected a bullish sentiment on the yen. My question is, isn’t more likely that that just reflects hedged carry trades? Another pair I can see that, but specifically with jpy it seems obvious calls would be in demand for hedges. I feel like I’m missing something…
No. I worked with Kathy Lien back in 2005-ish. The yen thing was correct then. Now it ain’t. You need to smooth correlations. If you feel like you are missing something, then ‘do not trade spot currency’.
Well, each currency pair does have its own unique “personality,” which typically reflects the intersecting national policies. The Yen is kind of a unique currency because of it’s status in the carry trade. I don’t know the details well enough, but probably it was just an illustrative example. IIRC, risk reversals are generally measured relative to a long term baseline. For things like stocks, puts are generally more expensive than similar moneyness calls because risk averse people are more willing to pay up for insurance-like protection in puts. But if the ratio of puts to call price changes dramatically over the baseline, that can tell you something about where the average option buyer sees risk.
You got it, there’s nothing to miss. Yes skew exists, as a perception of the forward distribution, of which, rates have an impact. Theoretically its edge, but practically not easy to capitalize on.