Currency volatility deters investors from taking risks

New York: Aggressive rate cuts by the Federal Reserve have failed to soothe investor jitters about a shaky US economy, spurring heightened currency volatility that will likely keep a lid on big risk taking for now.

That could weigh on currencies that have benefited from investors past willingness to take a chance, such as the Australian dollar and South African rand, while helping strategies that avoid directional bets.

Under normal circumstances, Fed rate cuts, which provide additional market liquidity, would have encouraged appetite for risk-taking and cause a decline in volatility.

Yet uncertainty abounds over prospects for a possible US recession and the threat that may pose for the rest of the world. That has kept the spot foreign exchange market jumpy and currency options prices elevated despite the rate cuts, analysts say.

"There is not a lot of light at the end of the tunnel and that has kept a bias for... volatility," said Mike Moran, senior currency strategist, at Standard Chartered in New York. "I think the short-term outlook clearly will hinge on several factors including asset market volatility and Fed expectations."

Index

BNP Paribas' index of currency volatility hit two-month peaks last week. While it has eased somewhat since, it remains more than 40 per cent above record lows reached back in October and about 30 per cent above its 200-day moving average. The credit crisis that unfolded in late 2007 awoke foreign exchange market volatility from a long slumber. Implied volatility of one-month dollar/yen options has been falling for most of the last decade.

That trend came to an abrupt end in August as investment banks began revealing billions of dollars in subprime mortgage loses and global stock markets started reeling. The 100-day moving average of yen volatility jumped to a six-and-half-year high in late 2007 and has remained near there since.

The sustained rise in volatility has had a devastating effect on carry trades, in which investors borrow in a low-yielding currency such as the yen to buy higher-yielding assets. This strategy requires a fair bit of risk taking since it assumes interest rates will remain relatively stable.

The dollar has dropped 10 per cent in the last six months against the yen.

Previously such spikes in volatility were considered selling opportunities because high volatility means high options prices.

In the current environment, however, falling house prices and eroding credit is making investors nervous, and most are keeping their long bets on volatility.