FX Vol Insight: A tale of two carries

Research evidence excerpt

FX Vol Insight: A tale of two carries

rch Source: BofA Global Research

BofA GLOBAL RESEARCH BofA GLOBAL RESEARCH

Volatility carry through forward vol exposures

Another type of carry which benefits from volatility grinding lower is outright volatility

carry. This exploits the tendency for the market to systematically overprice future

volatility. One way to measure this is through forward volatility levels implied by the

volatility term structure (or equivalently through FVA contracts referencing those

forward volatilities). Investors can earn carry either from rolling down the term structure

or by taking exposure to these forward volatility levels.

Across 144 combinations of G10 crosses and forward-volatility tenors, 140 (97%) have

over the past year seen the implied forward volatility exceed the future spot implied

volatility eventually observed over the corresponding period (Exhibit 4). This indicates

that the market has tended to overprice future volatility on average.

The tendency for forward volatility to be overpriced becomes even clearer when

examining the richest forward volatility pairs / tenors. To assess this, we rank G10

forward-volatility tenors each month by their 1-year z-scores and focus on the five

richest. Over the past five years, these elevated forward vols have overestimated

subsequent spot volatility 60-70% of the time, while the gap between implied forward

volatility at inception and the realized implied volatility ultimately observed averaged

0.28-0.45 vol points, depending on tenor (Exhibit 5).

This tendency has also been relatively persistent, only reversing during periods of

elevated volatility (Exhibit 6). However, as we expect volatility to rise around the US

midterms, we would be cautious about vol-carry strategies centered on November.