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Fx volatility part II

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Alright, time to go on about FX volatility. Some of you might have been waiting all week long for this post, while others already knowing it all might have to wait another week for another topic.

While last week we covered ATM and smile volatility, we are going to cover more advanced functions for FX volatility:

Cut-off spread

Cut-off spread is a spread added to the option volatility depending on which cut-off the option is on. One could also choose to have a time ladder for the spread (with a higher spread on the shorter term and smaller spread on the longer term for example). The idea behind the cut-off spread is to say that an option with NY cut should be worth a bit more than an option with TKY cut. You get indeed couple of hours more.
While Murex does not account for time when computing t for option valuation, the idea is then to increase the volatility (or decrease) to represent the difference in premium.

Short date model

The idea behind this is to say that each day is weighted differently for volatility. For instance, weekends could have a lower weight (one would argue that it could actually be 0), Fridays are usually quieter so you can define lower weight also for Fridays and Mondays might have a bit higher weight. You define what weight you want for each day and you see directly the impact in terms of daily volatility and interpolated volatility.

More importantly, you can define specific days (like fed announcements, US holidays) to have a very different weight to represent the special weight of such a day.

Short date model has a larger impact on the very short term (<3m), in Murex it goes up to 1 year but on the later months, the impact is minimal.

Smile dynamics

This could be input in the system or it can be computed using Tremor. The idea behind smile dynamics is to define the smile convexity compared to spot. So you define how much your RR and FLY (if this means nothing to you, you should read FX volatility part 1) will move by when the spot moves.

I haven’t seen it used by many people but it is there and ready to use.

I think that’s about it for extra functions in regards for FX volatility. If I forgot one you’d like me to cover, let me know!

2 thoughts on “Fx volatility part II”

  1. Hi,
    Your instruction of volatility is very thorough, this is really a good material for all Murex FX option front office users. I would like to ask if you could introduce more about FX cross pair vol surface ? I am recently working on cross smile generation.

    Thanks and Regards.

    1. Hi,

      Thanks for your comment. I don’t know if Murex has released recently a tool to be able to generate cross smile. This is actually quite tricky as you’d need a correlation matrix for the different pillars and delta ladder. Ask your Murex support on that one, but I’d be curious to know the answer 🙂

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