Buy EUR/GBP vol against cable vol – SocGen

In view of Olivier Korber, Research Analyst at Societe Generale, GBP/USD 1y implied vol is trading above EUR/GBP 1y vol, but EUR/GBP vol is now likely to outperform it which makes buying the spread a real opportunity.

Key Quotes

“The 3m realised vol spread is now turning positive in favour of EUR/GBP vol. Volatility term structures tend to be essentially driven by the 3m realised vol for all tenors.”

“The implied vol spread is driven by EUR/USD vol (GBP risk cancelled out in the spread), which is expected to rise from depressed levels.”

“EUR/GBP volatility to benefit from euro strength, as per the positive options 1y skew. Also, the options market is likely to bid EUR/GBP vol in a larger proportion than what the skew is predicting, if the spot breaks above 0.90 as we expect.”

“Expression Long/short of volatility swaps

As a pure volatility trade, we recommend getting pure volatility exposure via a long short of volatility swaps. This allows for getting rid of systemic delta hedging and more generally of most of the gamma risks. The pay-off of these instruments depends on realised volatility, but their market to market (vega) is sensitive to implied volatility as well.”

“Mechanics 

• Go long EUR/GBP 1y volatility swap                       
• Go short GBP/USD 1y volatility swap

Indicative bid for the spread: 0.2 vols (GBP notional for both swaps)”

"Risks: Cable vol exceeding EUR/GBP vol

A volatility swap is exposed to the difference between the traded volatility and the realised volatility observed at the expiry of the contract. Investors therefore face potentially unlimited losses if the spread between GBP/USD and EUR/GBP 1y realised volatilities exceeds 0.2 vols in one year.”