Last week, we looked into rates volatility, this time let’s dig into FX volatility.

Forex volatility – ATM volatility

This one is actually quite simple, you simply have a volatility for each pillar and each currency pair. As per other volatilities, you can link them together with spread and factor. The pillar set tends to be common across multiple currency pairs and is defined under the volatility groups.

But to make this paragraph more interesting, you can define a pair as not liquid and define a split currency. For instance if you’re heavy into TRY/ZAR (yep pretty extreme), you’ll be struggling to come up with a volatility curve for it. You can define volatility for USD/TRY and USD/ZAR. By also providing correlation (it can have different values depending on pillars), Murex can then compute TRY/ZAR volatility. (cross effect). While quite handy, providing correlation is also quite difficult as a task.

It is getting more frequent for rates, but for FX you usually interpolate on variance rather than volatility (vvt interpolation)

Forex volatility – Smile volatility

Smile for FX volatility is usually defined on a delta ladder. Usually you have a 10, 25%, 75 and 90 pillars.  Call 10, call 25, put 25 and put 10. A call with 90% delta has the same volatility than a 10% put.

But more interestingly, the smile is usually quoted in Risk Reversal and Strangle (or fly)

RR25 = Delta call 25 – Delta  put 25

(so effectively that’s the difference between call and put for a given delta level)

STR25 or FLY25: (Delta call 25 + Delta put 25) /2

You can easily switch from one to another within Murex or even display a smile with 5% delta increment in case you need a better view of the volatility (Murex can also display corresponding strikes)

Interpolation can be any of the usual: linear, spline, polynomial, etc…

 

I realize that I still have a fair bit to talk about in regards to Fx volatilities: Cut off spreads, smile dynamics, short date smile… So I’ll split this post in 2 with the part 2 next Tuesday!