Project Report

Risk Reversal Strategy

and analysis post BREXIT
Author: Shivang Arya, Master of Science in Financial Engineering from London
School of Economics

Project: Risk Reversal Strategy

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Abstract
The aim of the project is to analyze Risk Reversal strategy for FX options.
The Risk Reversal strategy I am going to explore is to buy a Risk Reversal (purchase
out-of-the-money CALL option and sell out-of-the-money PUT option) when it hits the
bottom 5th percentile in the time window and sell a Risk Reversal (purchase out-ofthe-money PUT option and sell out-of-the-money CALL option) if it hits the top 5th
percentile in the time window. While exiting the long position if it hits the 45th
percentile and covering the short position if it hits the 55th percentile. This is
because Risk Reversals become quite important when the values are at extreme
levels. When Risk Reversals are at these levels they give off contrarian signals
which indicates that a currency pair is overbought or oversold based on sentiment.

Background
A Risk Reversal is an options strategy which combines the simultaneous purchase of
an out-of-the-money CALL option with the sale of an out-of-the-money PUT option
(or the simultaneous purchase of an out-of-the-money PUT option with the sale of an
out-of-the-money CALL option) on the same currency with the same expiry and the
same sensitivity to the underlying exchange rate. The Risk Reversals are quoted in
terms of the difference in volatility between the CALL and the PUT options.
Many experts consider the Risk Reversal strategy to be a hedging procedure
although others consider it as an arbitrage since it entails the simultaneous
purchase of CALL and PUT options.

Strategy
Risk Reversal = (25 delta CALL)-(25 delta PUT)
Here a 25 delta CALL refers to an out-of-the-money CALL option where if the
underlying asset increases by 1 then the CALL option value will rise by 0.25 units
and delta is the first derivative of the value of the option with respect to the
underlying price. Now If the Risk Reversal is positive then it means that the implied
volatility of a 25 delta CALL is greater than the implied volatility of a 25 delta PUT.
Similarly if a Risk Reversal is negative then it means the implied volatility of a 25
delta CALL is lower than the implied volatility of a 25 delta PUT. Also if the Risk
Reversal is close to zero then this indicates that there is indecision about whether a
market is bullish or bearish and that there is no strong bias in the markets. The
implied volatility is the estimated future volatility (the expected change in price
over a given period). This is calculated using the Black-Scholes model.

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Options are trading all the time, so we can use the price that the market believes
the price of a CALL or PUT should be to calculate the implied volatility by working
backwards through the Black-Scholes model. For example Price of currency CALL
option with payoff max(S K, 0) in units of a domestic currency is:

C(S,T)= S*(d1)-K*exp(-r(T-t))*(d2)

[Where C(S,T) is the value of the CALL, S is the current stock price, K is the strike price, r is the risk
free interest rate (for which there are good proxies to find this data such as government debt), and (Tt) is the time till expiration.]

Now if we know the above parameters then we can calculate sigma (the implied
volatility) by using the Black-Scholes model above.
A reason to use Risk Reversals is if you want to hedge your underlying risk while at
the same time lowering the cost of the premium. A popular Risk Reversal strategy is
the zero cost trade in which you do not have to pay a premium. We can see this
using the strategy of buying an out-of-the-money CALL option and selling of an outof-the-money PUT option. Here writing the PUT option will result in receiving a
certain amount of premium which can be used to buy the CALL. Now if the premium
received from the PUT is equal to the cost of buying a CALL then we obtain zero cost
for this strategy, however the drawback to this is that it can expose the investor to
greater downside risk because of the short PUT option.

Testing and Analysis

To test my strategy I used the EUR/USD currency pair, I obtained test data by
downloading the 25 delta Risk Reversal of the EUR/USD from Bloomberg that had an
expiry for 3 months, along with the exchange rate and volatility for the time period
January 2013 to September 2015
I created a MATLAB code that used the test data I downloaded from the Bloomberg
site that provided me the OUTPUT graphs.
The percentile lines that I drew on the graphs are similar to the Fibonacci
retracements (a term frequently used in technical analysis) that refers to an area of
support (when a price stops going lower) and an area of resistance (when a price
stops going higher).

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In my model the bottom 5th percentile will be an area of support and the top 5th
percentile will be an area of resistance.

From the graph above I notice that every time the Risk Reversal hits the 95 th
percentile the trend moves downwards. At this point you sell a Risk Reversal so your
purchased PUT option will start creating profits if the market advances in a bearish
manner as anticipated. This process is in fact very similar to opening a short
position on its own, however the difference is that as a the price moves down the
CALL binary option (which you will have sold) will be reduced to zero by expiry time.
Subsequently you will then earn a profit from your PUT option at expiration while
receiving a zero refund from your CALL option. So you will have effectively created
an in-the-money win by not risking your own funds.
In the case your options have not expired and the Risk Reversal hits the 55th
percentile line and starts moving in a bullish position you would just buy a Risk
Reversal there in order to end up with a gross profit. After this point the Risk
Reversal continues swinging between the 55 th and 95th percentile for roughly one
year.

Exceptions
My proposed model held well apart from the two points where the resistance and
support levels were broken.
Around 24th December 2014 (day 520) my graph shows that the 25 delta Risk
Reversal becomes bearish very quickly dropping below the 45th percentile, implying
that the demand for PUTs sharply increasing relative to the demand of the CALLs.
To understand the reason why my model did not work at this point I collected
information of market events around this period. It occurs to me that this could have
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been due to the expectation of the euro to soften against the dollar due to the snap
general election in Greece. After this period my model behaved as expected with
the Risk Reversal moving between the 5th and 45th percentile until around 5th June
2015.
Another exception point I notice is around 5th June 2015 (day 644) when the risk
reversal hit an extreme at the 0.5th percentile and then became bullish very quickly
meaning the demand for CALLs was rising relative to the PUTs and so the Risk
Reversal graph rises and nearly hits the top extreme.
The reason for this exception could have been the Federal Open Market committee
interest hike statement and due to the USD/GDP ecostat coming in far lower than
the forecast at only 0.2% which caused the market to think that Euro would rise
significantly against the USD.

Further observations
From the exchange rate graph I noticed that the trend in the exchange rate is highly
correlated to the trend of the 25delta Risk Reversal which means that Risk Reversals
can be used as indicators of momentum in the currency market.
To further test my strategy I considered the time periods January 2007 to
September 2009 and January 2010 to September 2012 during the financial crises.

I notice that the strategy holds quite well during the 2007-2009 period apart from
around 20th September 2008 (day 463). Here the 25 delta Risk Reversal falls
drastically to end up below the 5th percentile; this was probably due to the market
expecting a softening of the Euro against the dollar due to the collapse of the
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Lehmann Brothers. However buying a Risk reversal when the 25 delta Risk Reversal
hit the 5th percentile would have been fine since after this point the Risk Reversal
rises and follows the proposed strategy and during the latter part of the graph it
fluctuates between the 95th and 55th percentile.

Again the strategy holds quite well during 2010-2012 period apart from around 12th
September 2011 (day 445) where I would buy a Risk Reversal and expect a bullish
trend in the long run however I notice that the Risk Reversal fluctuates frequently
during this period dropping to the 5th percentile again on 22nd September then
drops back down again for the period 3rd November to 7th November and it is not
until the 21st November that the Risk Reversal follows my model and rises in the
long term.
Here the fluctuations were probably due to the growing confidence that Euro-zone
officials were making progress in tackling the debt crisis by unveiling an enhanced
bailout package for Greece, while at the same time there were concerns about the
Euro where the president of the ECB confirmed that downside risks to the Euro-zone
economy had increased over the past month.

Analysis post BREXIT

Next I will test the accuracy of my strategy during BREXIT on the EUR/USD currency
pair as well as testing it on the GBP/USD and EUR/GBP.

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The strategy again works pretty well from 12th October 2015 till 15th July 2016 for
the EUR/USD 25 delta Risk Reversal. I notice that there is a large drop around 11th
June 2016 (day 142) which was probably due to the warning by the ECB of Euro
zone damage but after this point the risk reversal follows my strategy and rises until
24th June 2016 (day 154) where it falls slightly because of BREXIT results. However
the risk reversal rises very quickly after this point and finished above the 45th
percentile.

For the risk Reversal graph of the currency pair GBP/USD the strategy works well
where it fluctuates near the 95th percentile and then between the 95th and 55th
percentile until around 22nd march 2016 (day 581) where the is a sudden drop in
the 25 delta risk reversal this might have been caused due to Hawkish comments
by FED officials. Around the time of BREXIT results (day 48) the risk reversal hits the
5th percentile and starts to rise which follows my strategy.

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My Risk Reversal strategy again works quite well on the EUR/GBP currency pair
where it fluctuates between the 5th percentile and 45th percentile until a sharp rise
around 16th February 2016 where it rises quite quickly going above the 55 th
percentile which might have been caused by investors betting on the odds of the
ECB opting for fresh monetary loosening measures in March. After this point the
Risk Reversal fluctuates between the 55th and 95th percentile before crossing the
95th percentile for a short time and the decreasing again, this follows my strategy.
BREXIT (day 648) does not have a huge impact on the 25 delta risk reversal for
EUR/GBP where the risk reversal decreases slightly before rebounding from the 45 th
percentile and then dropping again.

Conclusion
To conclude I believe my strategy of selling a Risk Reversal at the top 5 th percentile
and buying a Risk Reversal at the bottom 5 th percentile, worked well during the
three different time periods and worked well on the currency pairs I tested on after
the event of BREXIT. The advantages of using Risk Reversal strategies are that they
can be implemented at little to no cost and are designed to have favorable risk
reward. Also they can be used in a wide variety of trading situations. The
disadvantages of using Risk Reversal strategies is that the margin requirements for
the short leg of a Risk Reversal can be substantial and may exceed the risk
tolerance of an investor.

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Project: Risk Reversal Strategy

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