COMMENT-Option prices signal FX volatility crisis

A broad FX option implied volatility plunge to ever new 2-year lows signals a potential crisis for those who rely on FX volatility to generate returns.

FX volatility is an unknown yet key determinant of an FX option premium. Any disparity between implied and realised FX volatility creates a trading opportunity. However, when implied volatility is very low, sellers become reluctant to risk unlimited losses for limited rewards, while buyers are less likely to risk premium if the outlook for FX realised volatility remains subdued.

Past FX realised (historic) volatility can be a bellwether for future FX realised volatility, but that's trending lower too, and is already at a discount to implied volatility.

FX volatility is typically driven by the outlook and implication of policy and interest rate divergence and often led by the U.S. Federal Reserve. However, despite the extent of Fed rate cuts being reduced and the timing of those cuts being extended, the rate view in other major economies has been adjusted in a similar fashion. Risk sentiment is another driver, but that's favourable as demonstrated with stock markets trending ever higher.

FX option implied volatility posted its latest plunge in the wake of Tuesday's U.S. CPI data, which was basically in-line with expectations and unable to alter the current interest rate outlook. Even JPY related implied volatility is under pressure, although the risk of a Bank of Japan policy shift next Tuesday, is still evident.