Wednesday, October 24, 2012

risk reversal represents ... skew sentiment

RR (risk reversal) is a quantitative indication of skew. As a key soft mkt datum, it focuses on and expresses a specific aspect of market sentiment. A lot of raw market data distill into this one number.

See P 118 [[FX analysis and trading]] (Bloomberg Press) -- Positive RR represents bullish sentiment because call i-vol (surge insurance premium) is higher than the comparable put i-vol (sink insurance premium). That means more insurers feel surge is more likely than sink. Here we assume just 2 risks exist in this simplified world -- surge and sink.

Another source says positive risk reversal implies a skewed distribution of expected spot returns composed of a relatively large number of small down moves and a relatively small number of large upmoves. But I find this statement ambiguous.

Note for equities, put i-vol always exceeds call i-vol, so skew is always negative. See other blogs.

In a wider context, there exists a wide range of transformations (and extractions) on raw data including historical, economic and issuer data. Techniques vary between markets. Even between 2 players on the same market the techniques can vary widely. There are entire professions dedicated to data analysis -- quant strategists and quant analysts and quant traders. Among data transformations, RR is one of the most essential and part of the industry-standard.

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