Dollar Fear Trumps Greed in Prices to Protect Against a Rebound

Traders in the $3.2-trillion-a-day foreign exchange market are paying the highest prices in more than a year to protect against a sudden rebound in the dollar after its worst annual performance since 2003.

That possibility may be less remote, according to Bill Gross, manager of the world’s biggest bond fund, who says a prolonged period of record-low interest rates may foster the “systemic risk” of new asset bubbles. Dubai’s effort to delay debt repayments reminded traders how the U.S. Dollar Index surged 16 percent in the two months after the September 2008 collapse of Lehman Brothers Holdings Inc. when investors sought a haven from the turmoil and poured money into U.S. assets.

“American investors have a lot of exposure now to foreign markets,” said Mansoor Mohi-uddin, the chief currency strategist at Zurich-based UBS AG, the largest foreign-exchange trader behind Deutsche Bank AG as measured by Euromoney Institutional Investor Plc. “If investors become risk-averse again, which happened last year due to Lehman’s bankruptcy and could happen now for a whole host of reasons, they are likely to go into less risky assets like U.S. Treasuries, which would help the dollar.”

While Intercontinental Exchange Inc.’s Dollar Index fell to a 16-month low last month, implied volatility on three-month call options granting the right to buy the greenback versus the euro exceeded that for options to sell it by 1.61 percentage points. The Dollar Index tracks the currency against the euro, yen, U.K. pound, Canada dollar, Swiss franc and Swedish krona.

Risk-Reversal Rates

The so-called 25-delta risk-reversal rate, which was flat as recently as October, hasn’t shown such high relative demand for dollar calls since hitting a record 2.595 percentage points in November 2008. When the implied volatility of dollar calls exceeds puts, like now, the gap is expressed as a negative number, which would be minus 2.595 percentage points.

Investors are waiting for “the BOB event, a bolt out of the blue,” said John Alkire, the chief investment officer at Morgan Stanley Asset & Investment Trust Management in Tokyo. “The world had a mini-BOB,” when financial markets tumbled after Dubai announced plans to restructure some of its $59 billion in debt, said Alkire, who helps oversee $40 billion.

The Dollar Index had its biggest two-day gain in a month on Nov. 26-27, rising 1 percent, as Dubai’s proposal to delay debt payments shook investor confidence by risking the biggest sovereign default since Argentina’s in 2001.

It surged 1.54 percent on Dec. 4, the most since Jan. 20, after the Labor Department said employers cut the fewest jobs in November since the recession began.