Explainer - Implied Volatility: a window into FX market sentiment

Implied volatility is a key component of an FX option premium, but what is it and how is it useful to the wider FX market?

FX options are forward looking and often used to hedge or speculate on future scenarios in the FX spot market. The probability of any particular scenario happening is used to determine the option's cost - like an insurance premium.

Many of the factors that help to determine the option premium, such as the expiry date, current exchange rate, FX forward prices and deposit rates for each currency, are already known. However, FX volatility over the life of the option is not, and that's what implied volatility is - a stand-in for the real thing. FX option prices in the interbank market are often quoted by their level of implied volatilities.

FX traders can consequently use FX option implied volatility levels to get a feeling of FX realised volatility expectations, especially in the short term, where sub 1-month expiries have stronger correlation to FX spot volatility.

A good example is the current low levels of very short-dated implied volatility in G10 FX markets, which is consistent with the very low levels of FX realised volatility. However, benchmark 1-month expiry implied volatility is higher and well supported since it includes the U.S. election, warning of its its potential to increase FX realised volatility.

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