In 2022, Yoshihiro Tawada, head of FX-flow quant modelling at MUFG Securities EMEA, noticed an anomaly in the market for Turkish lira/yen options. During periods of market turbulence, the mid volatility of options – which theoretically should lie between the bid and ask levels – breached those boundaries, contradicting the assumptions behind models used to price exotics and leaving them wide open to arbitrage strategies.
The breaches are the result of a peculiar convention in the FX options market, whereby prices are quotes in terms of the volatilities for given deltas and expiry dates. Pricing screens typically display the volatilities for at-the-money (ATM) options, risk reversals and butterfly structures. These values must be converted to obtain the implied volatilities for the bid and ask levels from which strike…
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