Tuesday, November 27, 2012

RiskReversal negative bid / positive ask

Refer to the one-way RR quote in http://bigblog.tanbin.com/2012/06/fx-vol-quoting-convention.html.

Q1: What if 25Delta risk reversal bid/ask quotes are both positive?

As in the above example, dealer (say UBS) gives an RR Ask quote of 3.521%. Let's say we have some hacker/insider friend to peek at UBS database, and we find the call's Ask implied-vol is 9.521% and the put's Bid implied-vol is 6%. In other words, dealer is willing to Write the 25Delta call at an annualized implied-vol of 9% and simultaneously Buy the Put @i-vol of 6%.

Now we ask the same dealer for a bid price. Dealer is bidding 2.8%. Our friend reveals that dealer is secretly willing to Buy the call @i-vol=8.9% (Lower quote) and simultaneously Write the put @i-vol=6.1% (Higher quote).

If you compare the bid vs ask on the call, as market maker the dealer is putting out 2-way quotes to buy low sell high.

If you compare the bid vs ask on the put, as market maker the dealer is putting out 2-way quotes to buy low sell high.

In this scenario, RR bid is below RR ask but both positive.

Q2: Could an RR bid be negative while the ask positive?

Ok We are serious about Selling an RR. To get a better bid price, we ask Dealer2 (SCB) for a Bid quote. Dealer is bidding -0.2%. Our insider tells us this dealer is willing to Buy the call @i-vol=5.9% and simultaneously Write the put @i-vol=6.1%

Between these dealers, Dealer1 would be the best (highest) bid. Now Dealer1 withdraws its quote. Dealer2 is the only bid. Market best RR bid is now negative.

Q2b: When would be RR bid and ask have opposite signs?
A: I guess when the 2 currencies are almost equal in terms of downside/upside

Q3: what if best RR bid and best RR ask are both negative? I think this is the norm in some currency pairs. Suppose market is bearish on the commodity currency (1st) and bullish on the quote currency (2nd). Treating commodity currency as an asset, Sink insurance costs more than surge insurance. Put premium exceeds Call premium. RR would be negative in both bid and ask.

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