Euro/Swiss franc risk reversals

Background: Two concerns of our clients in 2003 have been the low level of interest rates and the softening of the US dollar. Finding investment solutions for these problems is compounded by the fact that our investor base generally tends to come from three home currencies -- Swiss franc, euro and the US dollar -- and they tend to be fixed-income investor dominated.

This presents three interest rate curves against which investment decisions are based and the relative currency strategy opportunities are evaluated. Our preference is towards simple FX strategies that can either hedge currency risk or provide extra yield to investment strategies.

Problem: Most Swiss investors face low domestic investment rates and a softening Swiss franc versus the euro. The low interest rates and the aggressive monetary policy stance of the Swiss National Bank (SNB) aimed at softening the Swiss franc versus the euro have encouraged the use of the Swiss franc as a funding currency versus the euro and the near euros of sterling and Swedish krona. Due to the high correlation of Swiss franc to euro versus dollar and the lower level of comfort investors exhibit when they move outside the eurozone influence base, use of the Swiss franc as a funding vehicle for investment in other regions, such as the Australian or Canadian dollars, encounters greater investor resistance. This also goes against the SNB’s operating method. The SNB monitors the euro/Swiss rate and sets policy accordingly. It acknowledges moves in dollar/Swiss but does not employ policy based on movement versus the dollar.

Solution: Our preferred currency strategy for the Swiss franc for 2003 has been the use of a simple euro/Swiss risk reversal. These strategies are directionally orientated, and given our bias towards SNB policy we have only recommended long euro/Swiss strategies. In a base country where interest rates are at ultra-low levels, the pricing of the risk reversal takes double advantage of the interest rate differential. The buying of a euro/Swiss call earns the interest rate differential embedded in the forward, and the selling of the euro/Swiss put earns the interest rate differential again. This strategy appeals to an investor who is directionally biased in a low interest rate currency.

This favourable pricing element allows the strike prices to be altered to levels that appear more comfortable to the cautious investor or to create ratio strategies for the more aggressive investor. Also, the skew in the premium has favoured this strategy for most of 2003. You are selling the higher volatility option.

While the Swiss franc has been weakening versus the euro for most of the year, the pace has been relatively modest. There was a slightly more accelerated pace from March to June, when the SNB first started to increase money supply dramatically, and it has been at a more moderate pace since. The more moderate recent pace has suggested the purchase of call spreads instead of the simple euro/Swiss call. Given the low volatility of euro/Swiss, entry level is critical and another reason we only trade in the directional bias of the central bank.

We forecast stable SNB policy for the next three to six months, and continue to recommend the strategies used above. We expect the SNB will tighten policy before the European Central Bank, and possibly remove some of its aggressive monetary stance in late Q2. Currently, the SNB’s more aggressive monetary policy should keep the Swiss franc on a modest weakening trend, but the first signal from the SNB that some amount of this accommodative policy will be retracted will also signal the end of the euro/Swiss appreciation trend.