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Randor
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Posts: 72
Joined: October 8th, 2005, 8:33 am

seemingly paradoxical relationship between risk reversal and digital price

March 20th, 2020, 1:42 pm

how do we resolve this seeming paradox?
lets take GBPUSD now:  it has a negative risk reversal, ie putvols > call vols , because traders expect spot to fall, so they are buying puts, pushing their vols up.
and if the risk reversal becomes MORE negative , then based on the above, you'd say theres even MORE expectation of the spot falling.
HOWEVER, if you actually go ahead and request a quote in the market for betting on the spot falling , eg a 3month european digital put (which are priced as leveraged put spreads, ie taking into account slope of vol smile), you'll see that when the RR becomes more negative , the digital price (which represents traders view on the probabilty of the payout occuring) goes DOWN , despite that we established above that traders think that change in RR means the prob goes UP!
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