FX Option Performance – an interview with Jessica James

Jessica James discusses her book FX Option Performance co-authored by Jonathan Fullwood and Peter Billington.

Published: 6 July 2015

Jessica James discusses her book FX Option Performance co-authored by Jonathan Fullwood and Peter Billington.

Jessica James is Co-Head of the FX Quantitative Solutions team at Commerzbank in London. She joined Commerzbank from Citigroup where she held a number of FX roles, latterly as Global Head of the Quantitative Investor Solutions Group. She is a Managing Editor for the Journal of Quantitative Finance and is a Visiting Professor at Cass Business School. She is a Fellow of the Institute of Physics and has been a member of their governing body and of their Industry and Business Board.

Jacob Bettany: Could you tell us a little about yourself and your co-authors?

Jessica James: My background is in physics. It is all such a long time ago but I like to think that I’ve kept a bit of a physics attitude and taken it through into finance. I’ve always had an interest in the mathematical aspects of finance and I’ve always been in the quant area, but I think perhaps unlike the majority of quants I’ve always been a bit obsessed by data. It seems so important to me in physics that you can only confirm a theory by experiment, but in finance I don’t think there’s enough focus on data to actually see whether theories and ideas and models relate to the real world. So throughout my career I’ve tried to check theoretical assumptions against actual market data. One of the things I’ve always done a lot of is back-testing strategies for customers. I started off as an interest rate quant for six or seven years. I published my first book with Wiley Interest Rate Modelling in 2000 co-authored with Nick Webber. Shortly after that I moved into the foreign exchange area which I liked very much as there was a bit more of an emphasis on data.

I started working with my co-authors Jonathan Fullwood and Peter Billington when I got to Commerzbank, and because Peter is a very experienced option trader with a maths background and Jonathan is an incredibly good quant who also has a physics background, we were really able to get a comprehensive picture of the market and its history.

I am delighted Commerzbank chose to sponsor the book. They were very supportive at all points and I don’t think everywhere would have been.

JB: Would the type of information you’ve published in this book usually be kept secret? What was your motivation for sharing your findings?

JJ: Personally, I do not want to go and try to start up a hedge fund and use this information; it’s not my interest. I’ve always been a scientist at heart and my true pleasure is in disseminating discoveries. I have been very fortunate to work at a client centric organisation. Commerzbank is very much about serving middle Germany. And because the book fits well with the modern ideas of transparency, openness and trying to do the best for the client, it was very much a happy confluence of different circumstances. I can imagine that there are other places I could have been working when I would not have been able to publish this. Financial research can never get as far as it should because you seldom share your resources. If you don’t share your information you always have the same hill to climb and there is a huge duplication of effort.

JB: Could you give us some context for the FX option market in the broad scheme of things?

JJ: The FX spot and forward market is enormous. The BIS report 2013 gave it 5.3 trillion dollars of flow per trading day. Now that obviously is due to a lot of different types of flow. But nevertheless the option market itself is about 300 billion dollars per day. What is this due to? There are all kinds of different flows which go through FX options but you can’t neglect the fact that investments are now global. Our parents’ pension fund would have been local. Now our generation’s pension funds will have a global mandate with an allocation for alternatives. What’s happened is that the world has diversified and with that comes attendant foreign exchange risk.

JB: Could you outline a summary of the conclusions you made in the book?

JJ: It’s that carry is very important. FX spot today is a better predictor than the forward rate of spot in the future, so mostly puts are more valuable than calls. Implied volatility is slightly overestimated versus realised, and out of money options are poor value relative to at the money options. Those are the three critical things.

JB: Who will find this book most useful?

 JJ: A number of different readers will, but I see firstly corporate treasurers; those who are looking to hedge, so the companies who have exposures at foreign exchange and are wondering what to do about them. Next I would put investors, again those looking to hedge but also those looking to build strategies so this will help them – I cannot use the Newton quote about standing on the shoulders of giants because that would be saying far too much about my little book! But at least they will not be reinventing the wheel so it will give investors a leg up and they will be able to see where opportunities might lie. Also students will find this book useful to study the FX option market.

JB: How is the book structured?

JJ: We have an introduction and then go over some history, and I was very pleased to find some little bits of history that I’ve not found anywhere else. The first foreign exchange option was done through the Philadelphia Stock Exchange in November of 1982. I know that because Neil Record of Record Overlay told me, because I think he was there. But you will not find any other record of where the first FX option was traded. That was an American option. There was no model to value it, because Garman and Kohlhagen published their paper on Black-Scholes pricing of FX in ’83. By the mid-80s the Chicago exchange had taken on options and was trading them very liquidly so that was obviously very successful very quickly. The other thing I was particularly interested in as a fact from history was the development of the FX option market was not led by quants or traders but was led by corporations, because they were the ones who had FX exposure. They realised you could do a forward and then if it was seriously positive or negative you could buy it back. They were crudely doing option replication so the first overlay companies arose to do that for them.

Then we do a brief bit of theory but I didn’t particularly want to go into a lot of detail about pricing models since the only one we really use is the standard Black-Scholes-Merton – you don’t need any others. And then we go into the data so first of all you look at the straddles, the out of money options, the puts and calls, and really dig into the way that different anomalies offset each other with a lot of graphs and tables. Then at the end we’ve got a section on the carry trade – because it all really comes down to the carry trade. What the different ways of doing it can be – can you do it with options, does it really exist? And then in the end almost as an afterthought but now I’m really happy it’s there, is a little summary box and diagram of every discovery. Finally we have an enormous appendix with over 100 data tables! I thought if I was a student I would really like this because I can download data to can test results. Because if you’re a student and you’ve calculated the price of a call option, a one month call option and it says 2% – is that right? How will a student know? So once they’ve got something to really check against that will be really handy for them.

JB: Could you tell us a bit about the process you went through which led to making the discoveries explained in the book?

JJ: A few years ago I started noticing that foreign exchange options were consistently showing some anomalies; in particular short dated options seemed to be a bit expensive. The long dated options seemed to be cheaper. We finally decided that we would be able to comprehensively see what had been going on so we aggregated all the data we could find for foreign exchange options, going back to 1995/1996 when the databases mostly started. We did a huge amount of analysis and found that one thing I’d seen before was confirmed; that short data options were a bit expensive. You paid about 20% more than you got out. I looked at this payout to premium ratio and found that payout was about 80% of premium.

I had always looked at straddle options because I didn’t want to be over influenced by a market trend. But then finally I split it up into puts and calls and found that on average in all the market data that we have the longest dated calls pay back only 50%. The longest dated puts pay you back 130%.

High yielding rates imply depreciation in the currency which doesn’t occur on average. Now, if it doesn’t occur on average you have a problem. In the spot market this is expressed at the FX carry trade. People didn’t believe in the FX carry trade for years and having spoken to a lot of the folk who were there at the start of the FX option market, everyone pretty much believed that the forward rate would be a reasonable predictor of future spots. Then after some decades of the carry trade it became apparent that this is not so. It was explained as a risk premium or a return premium but the fact remains that what was not anticipated was that spot would be a better predictor of spot than forward rates.

Once we’d realised there was this really quite serious difference between what you pay and what you get on average and that there is a good reason and that is actually likely to reoccur – I remembered all the times that I’d sat in front of folk from corporate treasury in different, very substantial companies, and showed them that for example they could have hedged their Brazilian Real exposure at one third the cost using options instead of forwards, and their amazement. This is information that could save large companies enormous amounts of money and help them judge where their risk is. Conversely for investors, pension funds, insurance companies this is a possibility to develop strategies that could take advantage of the opportunities.

JB: What happens if everyone does do that?

 JJ: The simple case is that if the price is too low, people buy and it goes up. But there is not that much you can do about the forward rate because it’s defined by arbitrage. So in order to get from now pounds to dollars in the future you either invest an exchange or exchange and invest and that finds the forward rate. If you quote a different forward rate people will arbitrage it out. So you can’t really get away from the forward rate. You can’t really get away from the implied volatility distribution either because if you widen it too much so that effectively it blurs the forward and the spot rate together people just keep selling it because if the implied volatility is much larger than the realised volatility it’s worth selling options. So there’s not a lot that could directly be done. Also it’s not a get rich quick strategy. Could you sell short dated options to make money? – Yes. Hedge funds do it all the time. But it is a famous ‘pennies in front of the steamroller’ trade. So to suggest that somebody just goes and sells options would be to advocate an extremely high risk strategy which has been the downfall of several hedge funds. You would not want to do that or you would want to do it in a protected way. If you say okay, buy long dated options, again it’s not that it doesn’t work but you’ve got to wait a year or two years for your money. So it’s a very different kind of risk and returns can be flat for two – three years at a stretch. Now – is there more fascinating stuff to do in the middle? Maybe. And I would like to sit down with an option trader and think of a carefully designed strategy.

JB: What was the biggest challenge you encountered when writing the book?


JJ: The data. And I could not have done it without Jonathan. He had everything perfectly laid out! Flawless. And I just don’t know if I could have really got it all organised and sorted without him. The detail is everything. It was a tour de force actually.

JB: This is why we are seeing more data scientists come in as quants, over the last ten years.

JJ: Yes – but still, I think this may be (I might be wrong) one of the very first books to actually look at what you got in history as opposed to what you might get if you did something. There are so many books on investing but I see very few of them give you backtested returns. I could pick off the Amazon screen 20 books on something like technical analysis trading, none of which would show you how much it has made. So it seems so important to actually show people what you can get for the money you pay. There are so many deal types that you can’t do this with because the data is not available. This was the deal type that I could get a long data series for. There are many other deal types that are liquidly traded and have been for some years and don’t have that kind of data history.

JB: So acquiring that data could put you at a strategic advantage?

 JJ: Wouldn’t it be better if nobody was at a strategic advantage? Wouldn’t it be better if something like a central bank or one of the regulatory bodies said please, give us your data and we will make it publicly available. We will not disseminate any proprietary information. This is just very simple market data that your average corporate treasurer could use. One of the things I was really delighted by with the book was that Wiley made the data tables downloadable. There must be over a hundred data tables and you can get them in an Excel form. You get the data set edition and in that there’s a code that allows you to download from the website. So if you’ve got a company treasurer who is investing in South Africa and wonders whether he should do forwards or puts or calls, he can go and look up in the back which contracts have worked best.

JB: Has the marketplace for foreign exchange options plateaued?

JJ: Not according to the last set of data I’ve seen but that was in 2013. The next one will be in 2016 and I’ll be very interested to see what happens. FX flow continues to power ahead – that perhaps is due to a lot of high frequency activity. Perhaps that will tail off, I’m not sure it’s kindly looked upon by regulatory organisations. Will FX options continue to be more and more used? I would be very interested to see.

JB: Would you be surprised if they weren’t?

JJ: I’d be surprised if they went down because I’ve seen no reason at all for their use to diminish. In fact since late last year there’s been an upsurge in general market volatility and so more need to be aware of potential swings in all of foreign exchange and also fixed equities and fixed income. Equity markets are now becoming quite volatile and people are looking ahead to see if there’s going to be interest rate rises so  wouldn’t see a diminishment in demand for them at all.

JB: There are more participants now.

JJ: There is more accessibility I would say now. A small or medium company can find different platforms that will sell options. It’s not just a voice trade done by the large corporations in the world, now a small company can find prices online, trade to protect themselves at lower spreads. So it’s simply become I think a bit more commoditised.

JB: To what extent are the patterns you have identified going to repeat in the future?

 JJ: Well, as they say, past performance is never a guarantee of what’s going to happen in the future! One thing that’s a little different now in the G10 currencies is very persistent low interest rates so very small carry differentials, and that gives you less of a difference between spot and forward rates. In emerging markets there are still significant carry differentials and these markets are becoming more and more opened up, more and more widely traded. So there’s no lack of this effect, it’s shifting around a little bit. Because of the current market we will see only a small effect in G10 at the moment with a larger effect in emerging markets, but there doesn’t seem to be any reason for them to go away.

The book doesn’t cover China, because there wasn’t very much data. About a month ago one of my colleagues said “do we have anything on China?” and we pulled out everything we’ve got on China and plotted the same graphs that we’ve got in the book and they come out exactly as you would predict. So although China is a more controlled currency than many, there is a persistent interest rate differential and you see precisely the effects that you see in other currencies.

JB: How will the FX options market evolve?

JJ: I think they should be more used because I think they are highly liquid instruments with a solidly based secondary market and no ambiguity about their value. They tend to be lumped often with other derivatives of a less transparent nature and, for example, in hedge accounting options are sometimes at a disadvantage. I think this is a pity because I think they are one of the most useful financial products and I would like to see a distinction made between these highly liquid instruments that have been priced the same way for 30 years and more opaque instruments where there is no data history.

JB: What is preventing people from using FX options more?

JJ: I think it is partly due to nervousness, and also some accounting and regulatory treatments in different countries favour forward contracts over options to some degree. Additionally, some companies will have internal policies which limit derivative usage and options can fall into this category. It was perhaps almost easier when folk had only a verbal description of the option trade, stating that it is the right but not the obligation to enter into this contract at this rate at this date.

JB: Tell us about the work you do with students.

JJ: I’m associated with CASS and UCL. I’m a visiting Prof and it’s such a pleasure to work with these super bright young people. As a student you need a wider context. If they’ve studied physics they come into the market and have questions and if they don’t get into the right background, history and data they don’t always know which are the things they should be doing. I hate to see wasted effort, for example, when you can come to the end of a project and find something was the wrong way round at the beginning. So I think if students didn’t have to keep reinventing the wheel it would be brilliant.

One of the things that drives me wild is that whenever I have a student’s project that I am supervising then the first half will be the student struggling to get the data out. There will be a Bloomberg terminal with a download limit so they will have to go there every week and download a bit more data, they won’t know which series is which, they won’t know how to do it because it’s not something they’re particularly trained in. They may never get the right data because they don’t have a trader to ask. Then they may do a horrible truncated project on this series of data that’s perhaps not even right. Students need to have a clean data set regularly updated with common pricing functions written by students embedded into its library. So a project then that gets its own credit can become another brick in the wall.

JB: There’s definitely a market for a consolidated database available to the academic community.

JJ: What happens is that different academic communities will try and hook up with an individual data provider but there’s no consolidation. I don’t know though if an academic institution would be able to share or even if you could persuade more than one, that’s why I’m saying central banks and regulators. I think that’s almost where it has to come from.

Why don’t you have a six month lag, so the student is always getting six month old data? That would completely satisfy most of the Bloomberg constraints and then the regulator or central bank can go to the different institutions and say do you have a bit more of this? Thank you very much and here’s a list of credits. But then they would have the actual information to set up such a database.

I am one of the editors for Quantitative Finance and I see a large number of submissions where the data set is inadequate. Somebody will submit a paper claiming to have found something very interesting and they’ve looked something like seven or eight years of the Brazilian stock market. I say, you cannot make any general statement without having looked at many, many markets in many different regimes! So in a way we had a closed problem while writing the book because we didn’t have a whole universe of stocks we just had the traded FX rates.

JB: Do you see more women coming into the field than previously?

JJ: Yes, I think the supply has improved but there is a way to go, particularly at the senior end. At the recent Global Derivatives conference there were 4 women speakers out of about 100.

JB: What is stopping them?

JJ: Here’s my theory. Let’s just assume a slight disadvantage to women, say a 5% disadvantage, at every big career decision point. And then let’s think how often these big decision points come up. Now in the British civil service, it wouldn’t be often, say every seven or eight years – it is famed for its long and continuous employment. I think in dentistry as well, and in the National Health Service, you could be a GP in a Practice for 20 years very happily. In Finance, I’d say there are maybe 18 months to 2 years between decision points – it’s very fast moving. Now, we’ll just use compounding and assume that for whatever reason – children, perceived performance, lack of aggression, any reason at all, there’s about a 5% disadvantage to women. If you compound it over ten years you’ve got hardly any women left at the end of it. If you’re in a slower cycle environment then it’s not a problem. So I think that’s a large part of it. I don’t think we have to say exactly where the disadvantage is just that there is one and in very fast paced environments women get filtered out.

JB:  Do you have any advice for women wanting to get into quantitative finance?

JJ: I’d say just totally go for it. Love your subject. Be really interested in it and don’t think that you should try and be a soft skills person because you’re a girl.