How Much Risk Is in the Euro?

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With a key European Union summit looming, the euro may not have priced in a truly dramatic outcome.

Got tail risk?

Not enough, at least when it comes to the euro, says Steven Englander, global head of G10 FX strategy at Citigroup.

Englander has looked at pricing in the option market to gauge how likely investors consider an extreme move in the euro in the next six months - in other words, tail risk. In his opinion, "investors are gravitating to a view that the sovereign crisis will play out in debt markets more than in currency markets." And that's now how Englander sees it: "to us, this looks to be an extremely hopeful view of how events will play out."

To gauge investors' view of euro risk, Englander examined the premium demanded for options that would pay off in the event of a 15 percent drop in the euro. The premiums are lower than they were last fall, which means investors aren't buying as much protection as they were before Spain and Greece reached their current crisis states. Option premiums are also modest in the other direction.

"For a crisis that dominates asset market moves and discussion, the actual risk that is priced into the tail seems remarkably low," Englander wrote in a note to clients.

The pricing is especially surprising given the pessimism surrounding the upcoming European Union summit. "Little is expected and little is likely to be delivered" at the confab, he told me. "By now expectations are so low that even agreement in principle to discuss euro T-bills (without any concrete commitment) or if the growth package can exceed the 1% already agreed on would be viewed as a plus."

Marc Chandler, chief currency strategist at Brown Brothers Harriman, is equally gloomy. The summit is likely to produce "at best, a road map of a road map" toward greater integration, he told me.

Be careful out there.

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