Currency Volatility: How low can it go? – Deutsche Bank

Sebastien Galy, Macro Strategist at Deutsche Bank, explains that as currency volatility drifts lower, it eventually reaches a point where it can no longer be compressed.

Key Quotes

“We suggest two different techniques to assess these minimal thresholds.”

“Implied currency volatility is expected volatility combined with a risk premium. In times of risk taking, fear tends to fade. Realized volatility drops during periods of trends or range trading, amplified by the hedging of derivatives. To assess the lower bound for currency volatility, we assume no risk aversion which is a contradiction in itself but it allows us to concentrate on realized volatility.”

“There are two ways to assess the lower bound of currency volatility 1. Assume that the currency is driven by interest rate differential and an autoregressive process as is typical in a risk on phase or range trading. Then assume that the sensitivity of the currency to interest rate differentials is zero. The currency volatility is therefore driven by a currency specific noise that is model dependent.”

“2. One can look at realized volatility for as long as G10 currencies have floated and assume that the lowest 1% quantile is the lowest level possible. This is no different than the usual boxplot approach except that it uses the entire available data. Note that when the currency has been managed such as in Switzerland it creates a biased estimate.”