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In addition to flow indicators, there are also sentiment indicators. These do not reflect flows directly going through the currency market, but more indirectly by representing the market’s bias towards exchange rates. A very useful indicator of market sentiment or “skew” is the option risk reversal. This is the premium or discount of the implied volatility of a same delta currency call over the put. For instance, a dollar–Polish zloty three-month risk reversal may be 3 vols, which means that the implied volatility on the 25 delta three-month US dollar call costs 3 vols more than the 25 delta dollar put against the Polish zloty.
Now let’s have a look at the risk reversals for the major exchange rates and the US dollar–zloty exchange rate. Given that it provides risk reversals across tenors, this produces in effect a risk reversal “curve”. How do we interpret this information? Clearly, the best way of doing so is by comparing current to historic levels. In this case, one should compare the current levels of option risk reversals as expressed by the results to a historic measure of risk reversals for those same currency pairs.
Options are priced off forwards and through this option risk reversals are priced off interest rate differentials. How do we price interest rate differentials? A key determinant for both the level and trend of interest rates is the current account. A current account surplus results in greatly increased liquidity, which in turn pushes interest rates lower. Equally, a current account deficit is an important factor in pushing interest rates higher. From this, we can say that term currencies with current account surpluses usually have the risk reversal in their favour. Thus, the dollar–Swiss franc exchange rate risk reversal should usually be in favour of Swiss franc calls. In other words, Swiss franc calls should be more expensive than Swiss franc puts. Equally, the same should usually be the case for dollar–yen risk reversals. If at any one time they are not, then this may represent a profitable trading or hedging opportunity.