Risk Reversals

Buying a “risk reversal” involves a combination of option transactions in which you simultaneously buy a call and sell a put of different strike prices, but usually of the same Delta. Conversely, selling a risk reversal involves selling a call and buying a put.

Supply and demand effects in the options market due to trends in the underlying instrument and customer requirements that involve hedging with purchased options often result in puts and calls of the same Delta having different implied volatility levels when they should theoretically trade at the same level.  When implied volatility is graphed as a function of strike price, this uneven effect is often referred to as the volatility “skew.”

The price of the risk reversal generally refers to the implied volatility difference for a call option versus a put option with the same delta in the primary quoted currency, and option traders routinely make markets in this difference.

The standard risk reversal quotation in the OTC currency option market is for options with a Delta of 25%, although markets can be requested for most risk reversal Deltas less than 50%, as well as for mixed-Delta risk reversals. Among professional currency option market-makers and traders, risk reversals are generally transacted on a Delta-hedged basis to avoid potential disputes over the spot rate.

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