The next obvious question is, what kind of smile and skew do we typically see in the FX options market? It's probably easiest to start with what we don't see. In equities and rates in log normal terms, we tend to see a strong and persistent bid for puts over calls in the risk reversals. This is caused by specific characteristics of each market, namely in rates, the tendency to use a normal rather than log normal distribution. And in equities, the commonly negative correlation between spot and implied vol that is market moves down are often accompanied by a rise in volatility. In both of those markets, there are also supply and demand effects from end user trading that can keep the skew bias in place. In FX options, we tend to see a more balanced outcome. We can still see risk reversals favoring puts in certain circumstances, but equally it is common to see them favoring calls depending on local market conditions at the time. Generalizing slightly, it would be fair to describe the FX options market as more smiley rather than skewed compared to both equities and rates. Certainly in log normal volatility terms. There are situations when a persistent skew can develop, and this tends to be seen in currency pairs where there's an event which is deemed to be contributing to a significant correlation between movements in spot and movements in implied vol. An example of this is if the central bank is currently intervening in the market, this type of intervention tends to be designed to move spot gently back one way, usually against a recent trend. And if continued tends to have a calming effect on the market. As supply and demand pressures are brought back into equilibrium by the actions of the central bank. However, if the central bank were to stop its intervention, then the spot market could see a dramatic move, and the anticipation of this will be reflected in the skew and risk reversal prices.

A good example of this was when the intervention from the Swiss National Bank in spot Euro Swiss was halted in early 2015. The market saw a dramatic move lower in the spot rate evidence of the possible correlation between spot and vol, which is priced into risk reversals when central banks are active in the spot market. Another good example is cable ahead of the 2016 EU referendum in the UK. It was deemed to be possible that if the vote went the way of remain, the market could see a moderate rally in sterling. But if the vote was for leave, then sterling could move sharply lower. Ahead of the vote short dated risk reversals in cable had a pronounced bid for puts as the market factored in the possible outcomes in both directions.