EFTA01148564.pdf

Glob J.P. Morgan John Normandi Arindam Sandilya 7 December 2011 Answers to 10 common questions on EMU breakup Previous J.P. Morgan research on EMU breakup • Client inquiries around euro breakup have risen Exiting EMU: the legal, the likely and the ludicrous, exponentially over the past month, probably Normand, February 19, 2010. triggered by the November German/French ultimatum that Greece should vote on its EMU Legal aspects of sovereign debt restructuring, Wadhwa, membership. Global Fixed Income Markets Weekly, December 10, 2010. Breaking up is hard to do, Mackie and Barr, September 2, • This note answers 10 common questions on EMU breakup based on J.P. Morgan research published 2011. over the past two years (see box). It also updates Rightsizing the euro won't make it more stable, Normand, hedging recommendations in the euro and proxy FX Markets Weekly, November 4, 2011. currencies given current levels of FX volatility and options skew. Long-dated (3Y-5Y) AUD puts/USD Euro: the make-or-breakup year, Normand, Global FX calls offer better value than OTM EUR puts/USD Strategy 2012, November 22, 2011. calls that have seen heavy tail risk hedge buying. • Given the unprecedented nature of a currency members are expected to share in the EU's purported union's demise on this scale, conclusions are advantages (prosperity) and its responsibilities (budget somewhat conjectural. This article reflects J.P. discipline). Potentially a country's failure to repay bilateral Morgan FX Strategy's interpretation of the Lisbon loans extended by the core during the sovereign crisis could Treaty, ISDA guidelines and standard industry be construed as a blatant violation of the solidarity contracts and not the opinion of its Legal principle, an act which may then motivate core countries to Department. Clients should consult their counsel as agitate for expulsion. Alternatively the core could attempt to the legal implications of the scenarios addressed to force a country to withdraw under Article 50 by in this note. withholding resources such as access to ECB funding for a country's banking sector. 1. How could the Euro area break up? 2. What would be Europe's successor currencies The Lisbon Treaty governing the European Union (27- under various scenarios? member trade bloc) makes no provision for exiting EMU N4, Although some countries outside the Euro area use the (17-member monetary union), whether voluntarily or by euro2, a weak country that withdrew or was expelled expulsion. It only provides a mechanism for countries to from EMU would need to introduce its own currency. negotiate their exit from the EU (Article 50). Since Whether this currency were a legacy currency (drachma) or monetary union is an explicit, legal requirement for all EU a newly-minted one is immaterial. The key point is that countries except those which have negotiated an opt-outs, within that country's borders, something other than the euro exiting the EU presumably requires exiting EMU. Thus has become legal tender, or the mandatory means for under current treaty provisions a country could exit the settling obligations (see question 5). monetary union by withdrawing from the customs union. There is no provision for exiting EMU while remaining in If core/strong countries withdrew, it is unclear whether the EU in order to secure a position similar to the UK's, in they would continue to use the euro or would introduce a which a country retains the rights of the free trade bloc but new medium of exchange. The ECB could remain the isn't bound by its policy rates and currency regime. Either central bank for some critical mass of countries, and since core countries could exit to avoid the costs ofmonetary the euro is understood to be the currency issued by the ECB union, or peripheral countries could leave to regain the and the national central banks within the euro system, the benefits of independent monetary and exchange rate policy current euro could continue to circulate as legal tender. (see question 4). A more contentious situation arises if the core splits into Even without recourse to Article 50, there is another perhaps a German/Austrian/Dutch monetary union versus a potential path to euro breakup. The Lisbon Treaty makes French/Belgian currency zone, both of which might wish to frequent reference to the solidarity principle under which 2 Monaco, San Marino and Vatican City use the euro under formal I The UK and Denmark have negotiated legal opt-outs while agreement with the hell, whereas Montenegro, Kosovo and Sweden's is informal. Andorra use the currency without an accord. www.morganmarkets.com/GlobalFXStrategy J.P. Morgan Securities Ltd./ JPMorgan Chase Bank NA The certifying analyst is indicated by an AC. See page 9 for analyst certification and important legal and regulatory disclosures. EFTA01148564 Global FX Strategy Answers to 10 common questions on EMU breakup J.P.Morgan December 7.2011 John Normaixl Arindam Sandilya J.P. Morgan Securities Ud.. JPMorgan Chase Bank NA retain the physical euro as their currency but operate number indicating where the bill was printed.3 This coding independent monetary policy under their respective central is analogous to the US system in which the 12 regional banks. Since no country or countries can claim entitlement Federal Reserve Banks print bills stamped with numbers 1 to the euro — the treaty defines the euro simply as the to 12, while four US mints issue coins. A country leaving currency issued by the European System of Central Banks EMU thus could declare that only the notes and coins it has and accepted as legal tender within the Euro area — issued are legal tender, hence obviating the need for ownership would become an issue for negotiation between franking. This approach is still cumbersome, however, since the two camps. (Note there is no international forum for notes and coins issued by various Euro area central banks sovereign arbitration on financial issues comparable to the circulate throughout the region just as U.S. dollar bills World Trade Organisation for trade disputes). If the core printed by the various Federal Reserve Banks course split, the question of who retains the euro isn't trivial given through American banks, cash registers and wallets. the logistical challenges of introducing a new currency (see Conceivably individuals and businesses may refuse to question 3). Recall that the physical euro was only accept euros bearing certain countries' printing codes, as introduced three years after the euro was launched as an one example of the tremendous payments disruption from electronic currency in 1999. EMU breakup (see also question 4). If the euro ceases to exist, either because all countries Given the scarcity of foreign exchange, the authorities revert to their legacy (pre-EMU) currencies or core would introduce capital controls and possibly multiple countries choose to launch monetary union under another exchange rates to limit and prioritize access to hard treaty, then several countries will need to rethink their currency. These mechanisms will be familiar to those who currency regimes. Those which manage their currencies operated in emerging markets in the 1980s and early 1990s, against the euro (currency floor of EUR/CHF 1.20 in and even in Iceland following the 2008-09 financial crisis. Switzerland, and euro pegs in Denmark, Latvia, Lithuania, Capital controls violate Article 63 of the Lisbon Treaty Bulgaria and Africa's CFA franc zone) would need to guaranteeing free capital movement, but that prohibition anchor to another currency or to a basket of currencies. should prove little constraint since the country probably They could also float their currencies (see question 6). would have petitioned to withdraw from the EU already. Micro-states using the euro as legal tender (Monaco, The new exchange rate probably would be floating, since the Andorra, San Marino, Vatican City) would need to revert to country's central bank would not have sufficient foreign their legacy currencies or adopt some other liquid pair. exchange reserves to defend a parity rate (see also question 6). 3. What are the practicalities of replacing the euro? 4. What are the economic/financial costs and In a modern financial market dominated by electronic benefits of EMU exit? payments and in a zone free of capital controls such as the Any country that leaves EMU regains control of its monetary Euro area, the switch to an alternative currency would need and exchange rate policy. These benefits matter more for the to be secretive and practically immediate to be effective. periphery than the core given the former's loss of Mere suspicion of a regime switch would be sufficient to competitiveness since EMU entry (chart I), less flexible labor drive massive deposit flight into euro accounts in other markets and therefore lesser ability to undergo the internal countries, or conversion into non-euro currencies outside of devaluation (reduction in real wages) which Ireland and Latvia the region. Most likely a country would decree overnight managed under a fixed exchange rate. Policy flexibility is less that the country's legal tender had changed from euros to meaningful for core countries such as Germany, Austria and the new currency at a declared conversion rate, and that all Finland given their wage restraint and resulting current account accounts and contracts would be redenominated surpluses. For core countries, the primary benefit of a smaller immediately to reflect the new regime. All financial Euro area would be avoiding the transfer payments between markets would be shut and banks closed from some period rich and poor regions which stabilize a diverse currency union. — perhaps several days — to allow the conversion (see One potential form of such payments is the contingent liability question 5 on contract settlement). Euro area members have assumed directly through EFSF Normally this bank holiday would also allow the authorities guarantees, or indirectly through the ECB's bond purchases to stamp physical notes and coins to designate them as an (the ECB is owned by the Euro area's member governments). interim currency until a successor can be minted and distributed. This interim step may not be necessary with 3 EMU exit since all euro coins bear the name of the country For notes, designation include: Y Greece, X Germany, V Spain, where minted, and all notes contain a letter in the serial U France, S Italy and M Portugal. The letter J has been allocated to the UK to account for the trivial odds that Britain ever joins the euro. 2 EFTA01148565 Global FX Strategy Answers to 10 common questions on EMU breakup J.P.Morgan December 7.2011 John Normand Arindam San:Jaya J.P. Morgan Securities Ud.. JPMorgan Chase Bank NA While the nature of the costs from EMU exit vary Chart 1: Unit labor costs indexed to 1999 (EMU launch) equals 100 ForMIMI:it Germany at 106 ndkales thal unt labor costs have increased by 6% considerably for core versus periphery countries, negatives tunas* since 1999. would be enormous for both camps. Since a peripheral 200 196 country would likely exit during a period of extreme market 170 stress and fiscal disarray, costs would include: very high 155 163 and even hyperinflation due to currency depreciation; 150 127 129 133134 135 139139 140 141 11 115 116 122 121in 0 high/higher bond yields due to risk premia for inflation and currency depreciation; sovereign and corporate defaults on 100 II euro-denominated debt; deposit flight from banks and capital flight from stock and bond markets to avoid forced 50 redenomination; breakdown of payments system due to uncertainty over contract settlement; loss of capital market 0 access for at least a decade; and potentially loss of 1 1 1 ! .1 5 1 111 4 1.2]ZtrE E.2. 0. 64 e w In Ozw of" r§" privileges from EU membership (trade, investment, citizenship). Spillover to the remaining EMU members is inevitable. Source OECD Countries considered structurally similar to the exiting state — due to high debt levels or uncompetitiveness — would Bonds are governed by domestic or foreign law, with most suffer self-fulfilling runs on their banks and capital markets local currency debt (e.g., a Greek bond payable in euros) from investors and corporates fearing that another country being governed by domestic law and external currency debt could exit or be expelled. Core countries would suffer (e.g., an Italian bond payable in dollars) being governed by massive wealth losses from corporate and/or sovereign foreign law. Almost 99% of Euro area debt (sovereign and defaults in the periphery, and cross-border commerce would corporate) is issued in local currency! These securities will collapse given uncertainty around contract settlement under be governed by local law and therefore exposed to new currency regimes. redenomination risk since domestic law can be changed at will. Once a country declares another currency to be legal The economic and financial impact for all of Europe would tender, foreign courts would in most cases recognize that a be worse than Lehman, which was only the most intense bond governed by the law of that country would then credit crunch in modem financial history. EMU breakup become payable in that currency. would combine that credit event with the collapse of Europe's payments and settlement system due to contract Foreign currency debt — bonds issued by a Euro area uncertainty. Given that modern economies subsist on credit country but payable in non-euro currency such as dollars, and contracts, it should be clear that undoing EMU under sterling or yen — are typically governed by foreign law most scenarios is the economic equivalent ofmutually- (English or New York) over which the EMU state would assured destruction. The only scenario under which EMU not have jurisdiction. In general, foreign courts are unlikely can be unwound calmly might be if a country exited in to recognize the unilateral redenomination by a country several years after deficits had been eliminated and growth exiting EMU of a bond governed by foreign law. Still, the had been restored. Of course if stability returned, there bondholder would be exposed to significant default risk would be no reason to exit other than nationalism or the since corporates and the sovereign may not possess desire to secure policy flexibility for the next crisis. sufficient hard currency to honor bond payments. 5. How would various types of contracts be settled? Currency and interest rate derivatives are usually subject to an ISDA Master Agreement which is in most cases Contract settlement under a euro breakup will depend on a governed by English or New York law. If the euro number of factors, including the governing law, currency continues to exist, transactions governed by such an ISDA of account or settlement specified in documentation and Master Agreement between parties located outside the the nature of the breakup (e.g., the euro continuing to country exiting EMU should remain enforceable. Like cash exist despite the withdrawal of a single or multiple countries bonds, currency and rate derivatives governed by foreign or the euro ceasing to exist). law are beyond the jurisdiction of local legislation so such 4 The range on this figures runs from 92% in Finland to 100% for France, Germany, the Netherlands, Ireland and Portugal. 98% of Greece's debt is local currency, 97% of Italy's and 99% of Spain's. 3 EFTA01148566 Global FX Strategy Answers to 10 common questions on EMU breakup J.P.Morgan December 7.2011 Jon, Normand Arindam Sandilya J.P. Morgan Securities Ud.. JPMorgan Chase Bank NA transactions cannot be legally redenominated into a Chart 2. Currency depreciations vs deutschemark during the ERM 1 successor currency. In practical terms, this insulation from crisis in 1992 %change in firstyear after currencygaga/managed NOBISM311abandoned redenomination risk may be irrelevant: if the country exiting EMU imposes exchange controls applicable to local 0% parties to transactions governed by ISDA Master 5% Agreements, a foreign counterparty may face delayed settlement or default risk. The ISDA Master Agreement -10% includes termination events that address the right of the parties to terminate transactions if performance becomes -15% illegal or impossible. -20% The above examples assume the Euro continues to exist as the legal currency for some large group of countries even -25% assuming EMU breakup. If the euro ceased to exist, either -30% because all 17 countries reverted to their legacy currency or Figand Sweden UK Spain %legal Average because even the core split (see also question 2), the issue of the currency in which obligations will be payable SourceJ.PAbrgen becomes more complicated and will likely be determined upon the basis of factors peculiar to the particular Chart 3. Currency depreciations vs USD during emerging markets transaction and may entail the application of the legal balance of payments crises concept of lex monetae (i.e., the law of the country issuing %charge in first year after currency peasitnanaged floatsAare abandoned. Yearshunin parentheses. the currency). 0% 6. How would various currencies — the smaller euro, the successor currencies and the non-European -15% S r.. currencies — move following EMU breakup? -30% Whether a large group of core countries exited or a weak country were expelled, EUR/USD would still collapse due -45% to capital flight related to redenomination risk or the resulting economic depression. A 20% drop to 1.10 is a fair a initial target reflecting several considerations: (I) previous regime shifts in Europe such as the ERM crisis delivered -75% - depreciations averaging 15% (chart 2); (2) a 1.10 level represents a 35% peak-to-trough move since the sovereign -90% crisis began in 2009, so would be equivalent to peak-to- trough moves after a global financial crisis such as SourceJ.PAkcen Lehman's bankruptcy; (3) institutional accounts are already both USD and JPY are likely to strengthen under such record short of euros; and (4) the G-7 would undertake events. JPY could outperform USD because Japanese coordinated intervention to stabilize markets. Depreciations investors hold huge net-assets in the Euro area (Y50 trillion in emerging markets following de-pegging have been much or €440 billion of bonds as of end-2010). Repatriation of larger at 60% on average (chart 3), but the nature of those such investment could push up the yen significantly and crises was distinct from Europe's in that most EMs owed EUR/JPY may decline as low as 80. In this scenario, debts in foreign currencies. EMs also had limited ability to USD/JPY will fall to 72. Concerted intervention by G-7 intervene in forex markets to stabilise their currencies, countries can be expected in both EUR/USD and EUR/JPY, unlike the G-7's longstanding discomfort with excessive but is unlikely in USD/JPY. volatility. Successor currencies in weak states exiting EMU would GBP/USD would probably fall half as much as the euro — probably decline at least 50% versus the euro. This move implying that EUR/GBP declines about 10% — but sterling would reverse their loss of competitiveness due to excessive cannot act as a proper safe haven given that the UK will wage growth relative to Germany since EMU's launch in also experience a very deep recession. EUR/JPY could 1999 (chart 1). It would also approximate the average easily reach 85 because of general euro weakness, while depreciation witnessed during emerging markets balance of USD/JPY probably remains within current range because payments crises over the past twenty years (chart 3). 4 EFTA01148567 Global FX Strategy Answers to 10 common questions on EMU breakup J.P.Morgan December 7.2011 John Normanl Arindam Sandilya J.P. Morgan Securities Ud.. JPMorgen Chase Bank NA The Swiss National Bank would probably abandon the experience from EMU breakup. Cross-border trade, EUR/CHF 1.20 floor for two reasons. First, inflows into investment and banking are much more extensive within Switzerland would be massive and the SNB may not want EMU than in former communist states or 19th and early to continue accumulating reserves in a currency like the 20th century Europe. euro that was disintegrating. Second, the SNB may not want 8. What are the odds of various scenarios over the to anchor its exchange rate to something as volatile as the next year? euro would be during a breakup. A EUR/CHF decline to at least 1.10 or 1.05 is likely. Africa's CFA franc zone, which Given that an EMU downsizing involves mutually-assured pegs to the euro, would face similar questions: remain economic depression for the region, the odds of countries tethered to a high-volatility currency in crisis, or re-peg to leaving or being expelled are low. Of the two breakup some other currency (USD) or a basket of currencies. scenarios — exit/expulsion of weak country versus withdrawal of a critical mass of strong countries — exit of Commodity currencies, Scandinavia and the emerging the weak is more likely at 10% to 20%. Generalized markets (ex managed currencies such as CNY) would fall breakup has odds of less than 5%. at least as much against the dollar as the euro would, given the global recession which would result from EMU Speculation of EMU breakup could rise materially this breakup. The superior fiscal fundamentals of those spring, however, since Greece will almost certainly undergo countries would be irrelevant for the first few months of the another round of debt restructuring after February 2012 crisis since they would experience massive capital outflows elections. Should Greece unilaterally renege on debt owed (investors are still long these currencies outright or through to its official (government) creditors — El l0bn pledged by bond/equity exposure) or reductions in the their trade the EU/IMF of which €65bn has been disbursed — the surpluses. As a reference point, note that these currencies country could be considered in breach of the solidarity exhibited a beta of roughly 1.2 to EURJUSD following owed the Union under the Lisbon Treaty (see question 1). Lehman's collapse and during 2011 deleveraging, Although it is unclear whether solidarity principles would suggesting they should fall against the dollar by 1.2 times be sufficient legally to eject a country, political pressure to the EUFUUSD move. Intervention is very likely, but only expel would be immense, in turn driving unpredictable after an initial collapse. amounts of capital flight and hedging as investors and 7. Are there any relevant historical precedents for corporates rethink the convertibility risk inherent in European exposure. Note that a further write-down of what EMU might experience if the union dissolves? privately-held debt would not trigger calls for expulsion Over the past century at least a half dozen currency unions since Euro area governments condone haircuts on private have dissolved, but almost all of these relate to the breakup sector creditors. of empires with undeveloped capital markets rather than a 9. What reasonable measures should corporates and highly-integrated trade and investment bloc such as Europe. investors undertake given the risks? Between 1992 and 1993 the ruble zone disintegrated progressively following the Soviet Union's breakup in If EMU breakup were a very likely event, then so would be 1991, as newly-independent states introduced national a European depression, a global recession and possibly a currencies. Similarly when Yugoslavia split into several global depression. How to manage currency risks — whether sovereign states in the early 1990s, Slovenia replaced the from redenomination or sharp moves — is one of several dinar with the tolar in 1991 before joining the euro in 2007. questions which should also include how to manage other Croatia introduced the kuna in 1994. In 1993 the inevitabilities such as earnings risk, cash and liquidity risk. Czechoslovak koruna was split into the Czech koruna and For investors, the extreme response includes being Slovak koruna before Slovakia joined the euro in 2009. overweight cash relative to risky assets and to hedge all exposure in currencies other than USD and JPY, which will Pre-World War II dissolutions include the Austro- appreciate in the event of EMU breakup. Hungarian Monetary Union which was formed in 1878 and dissolved into several regional currencies in 1919 when For corporates, the extreme response would be to hold the empire fell after World War I. The Latin Monetary sufficient cash to meet a year of liabilities in the event that Union comprising mainly France, Belgium, Italy, Spain and capital markets shut, and to be particularly focused on Switzerland was formed in 1865 and dissolved formally in hedging all Euro area-based non-USD or JPY receivables. 1927, another victim of interwar financial turmoil. While Consideration should also be given to hedging a greater interesting historically and perhaps for the mechanics of percentage and longer maturities of forecasted exposure as introducing new notes and coins, none of these examples part of a rolling and layering strategy. In terms of tenor, at foreshadow the economic disruption Europe would a minimum investors and corporates should hedge 5 EFTA01148568 Global FX S. Answers to 10 common questions on EMU breakup J.P.Morgan December 7.2011 John Normaixt Arindam Sandilya J.P. Morgan Securities Ud.. JPMorgan Chase Bank NA EUR/USD and EUFWPY exposure with a one-year horizon, operate under accounting constraints. As a result, we restrict given that sovereign stress will persist for at least this long the set of investable structures to single-strike vanilla (a longer horizon may be warranted depending on options that comprise the lion's share of option-based confidence in the forecast). Finally, corporates should corporate hedges in normal environments, and focus on consider protecting the USD value of non-USD cash as part optimizing the selection of option parameters that deliver of a net investment hedge strategy. Potentially these the best risk-reward. The generic approach to hedge responses could be impractical given the opportunity costs selection takes into account three variables: of holding excess cash and the hedging costs of higher- yielding markets. Question 10 examines the cost- • Valuations: It is preferable to own options that are priced historically cheap over those that are historically effectiveness of hedges from current levels of volatility and skew. expensive. We measure historical rich/cheap through the 2-yr z-score of option premia (number of standard This focus on hedging the long EUR currency risks leads to deviations that the current option premium is above its 2- the question regarding the measures to take with short EUR yr mean). Working with option premia directly (as positions. For corporates in particular, some form of opposed to volatility for example) has the advantage of hedging is prudent in all scenarios, given the high degree of taking into account spot location, fonvard points, levels uncertainty in FX markets at all times, much less during this of base vols and risk-reversals simultaneously and sovereign crisis. However, hedges in this direction should obviates the need for analyzing each pricing element be adjusted by hedging a smaller percentage within defined individually. rolling and layering bands and considering the use of options versus forwards. Use of options (see question 10) • Static carry: Carry is a catch-all for the P/L that accrues can reduce the potential negative settlement impact of to any investment due to the passage of time. For options, forwards and provide flexibility in the context of carry is a combination of option time-decay, slide along competitive risk. the fonvard curve, and slide along the vol surface as time to expiry shrinks. Owning options usually involves 10. What are the most efficient hedges given current paying away carry primarily through time-decay — volatility and skew across currencies? especially for shorter-dated options — for the right to Hedging EMU risk has been an recurring focus of benefit from a substantial move in the underlying recommendations published in FX Markets Weekly — exchange rate; smaller the negative carry costs, the more attractive the option. We measure carry of an option by depending on the policy outlook — and was revived in the year-ahead outlook published last month (see Global FX shrinking its time to maturity by three months (an Strategy 2012, November 22, 2011). Given renewed client arbitrary time horizon) and recording the change in premium, holding spot, fonvard curves and vol surfaces interest in the tail risk but also significant moves in spot, volatility and skews recently, this section provides a constant. framework for choosing amongst direct and proxy trades. • Projected P/Ls in large spot moves: This is the core of The selection of hedges must begin with a shortlist of the issue and not trivial to gauge. A 10% move in spot potential underlyings in which to buy options. This is not so delivers 10% returns for a cash hedge (before rate much an issue for corporates as it is for institutional differential effects); for an option viewed prior to expiry investors: the former are more or less restricted to the EUR- that benefits not merely due to the change in the cross against their home/accounting currency (EUR/USD underlying spot but also due to the surge in volatility, the for US firms etc), while the latter are unconstrained by effect is harder to quantify. It requires a forecast of vol geography and free to select from among a wider array of moves in response to a given spot move, which involves proxy currencies that are likely to perform in a Europe- subjective judgment. An alternative is to rely on the risk- driven meltdown. We detail ow hedge selections for reversal (or "skew") which captures the option markets' corporates and investors below for the euro as well as proxy prediction of spot and vol co-movement. In reality, large currencies. The possibility that the euro may not exist market moves often result in vol explosions that argues for broadening hedges beyond the pair in which significantly exceed skew predictions, hence using the accounts have direct exposure. latter results in conservative estimates of P/L for option owners. We compute projected P/Ls for all options under A. Corporates the assumption of an instantaneous 15% shock to In general, extreme (tail) hedging constructs are well EUR/USD spot as discussed under k6. advised to steer clear of complex option structures that are illiquid and could be difficult to unwind amid heightened Table 1 illustrates this framework with the example of market volatility, particularly for corporate hedgers who EUR/USD. For each strike/tenor combination, we record EFTA01148569 Global FX Strategy Answers to 10 common questions on EMU breakup J.PMorgan December 7.2011 John Normarol Arindam Sanctilya J.P. Morgan Securities Ltd.. JPMorgan Chase Bank NA the three variables discussed above, and highlight points on Table 1. Close-to-ATM strikes in EUFUUSD offer better trade-off the vol surface that provide their optimal combination between valuations, carrying costs and returns from a dramatic (assigning equal importance to each). The first observation collapse in spot compared to deep OTM options.... For any strike/tenor combination, the first number is the 2-year 2-score of option from the table is that there is no free lunch: the most premium te of sW. deviations current option prices are above their 2-r mean), the efficient hedges are more expensive upfront, yet offer the second nunter is the 3-month price carry as a (recipe of upfront premium and the best risk-reward in the end. For example, 6M 1.35 EUR third minter denotes the P/I. from an instantaneous 15% spot shock lower as a fraction of upfront premium. Carry is estimated by ageing options by 3-months, puts/USD calls offer the best cost-benefit in terms of the holing spot forwards and the vol surface unchanged. wMe directional PIL is upfront payment vis-à-vis the rate of price decay if markets computed by shocking spot instantaneously 15% lower, assuming vols to move as stay flat (i.e. 30%) and the potential return if spot collapses. predicted by current risk-reversals. Svikenencr combinations for each tenor that In contrast, lower strikes potentially pay out significantly provide the optimal combination of the three variades are highlighted in gray. EUR Pull USD Call strikes more as a fraction of the premium paid, but also decay 1.00 1.05 1.10 1.15 1.20 1.25 1.30 1.35 1.40 faster — for instance, 6M 1.00s losing 86% of their value in 0.9 0.8 0.7 0.6 0.4 0.3 0.2 0.1 0.1 unchanged markets over a 3-month horizon. Second, for 6M -86% -81% -75% -68% -60% -51% -I P:6 -30% -18% most tenors, close-to-ATM strikes offer better value, since 675% 632% 595% 559% 515% 459% 393% 323% 256% EUR put buying over the past year has already pushed up 1.2 1.0 0.0 0.7 0.6 0.5 0.3 0.2 0.1 1Y -36% -33% -29% -26% -23% -20% -16% -B% -9% the prices of deep out-of-the-money strikes to extremely 293% 290% 287% 281% 271% 255% 235% 212% 187% elevated levels (chart 4). Choosing between tenors is a 1.3 1.2 1.0 0.0 0.8 0.6 OS 0.4 0.3 trickier task since it partly depends on the conviction of 2Y -13% -12% -11% -10% -9% -8% -7% -6% -5% one's views on how quickly the EMU might unravel. We 182% 180% 178% 174% 169% 162% 153% 144% 135% typically advocate I -year options that provide a decent mix 1.5 1.4 1.2 1.1 1.0 0.8 0.7 0.6 0.5 3Y -7% -7% -6% -6% -5% -5% -4% -4% -3% of market liquidity and some of the more aggressive P/L 146% 143% 141% 137% 133% 128% 123% 117% 111% characteristics of shorter dated options. 1.7 1.6 1.4 1.3 1.2 1.1 0.9 0.8 0.7 4Y .4% .4% .4% -3% -3% -3% -2 , -2% -2% Table 2 repeats the same exercise for EUR/JPY, EURJAUD 127% 125% 122% 119% 116% 111% 107% 103% 98% and EUR/GBP to address hedging concerns of Japanese, 1.8 1.7 1.8 1.5 1.4 1.2 1.1 1.0 0.9 Australian and UK corporates respectively, summarizing SY -2% -2% -2% -2% -2% -1% -1% •1% only the optimal 1-year strikes for each in the interest of 117% 115% 112% 109% 106% 102% 98% 95% 91% conciseness (detailed tables similar to table 1 available on SOME .PAtigin request). We assume that a catastrophic drop in the EUR Chart 4. ...a dema d for disaster protec ion ha pushed up p ices leads to sympathetic declines in EUR/JPY and EUR/GBP of deep OTM EUR puts/USD calls dispro ortion tely higher (i.e. options are struck in the direction of EUR puts), while Premium (In by EUR) of 1Y 1.30 sbike and I Y 1.00 Sbike EUR putsrUSD calls EUR/AUD rallies due to the high-beta nature of AUD (i.e. bp EUR bp EUR 1150