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The demand for some protection in Korean assets is evident in risk reversals in the FX market.
But after visiting Asian based investors last week there is a clear preference to fade the risk and harvest the vol/skew premium. Last week we recommended a limited loss structure to fade the North Korea fears – USDKRW 3m DNT with 1159/1062 strikes – but we are reluctant to sell volatility outright given the unquantifiable tail risk.
Alternatively, a better hedge against the worst possible outcome is seen by paying 5yr NDIRS. Carry is neutral and in the event of a tail risk scenario local and foreign money is apt to seek the safe haven demand of US Treasuries; unlike in FX (due to reserves) there is no natural firebreak in rates.
We’ve been neutral on KRW as the rising geostrategic tensions on the Korean peninsula has certainly impacted domestic market sentiment. The USDKRW cross is 2% above the year-to- date lows, the KOSPI equity index is down over 3% in the past month (with foreign investors pulling USD3.3bn from local stocks since late July), and 5yr CDS is up 10bps over the same period.
However, these moves are very much within the historic norms in terms of periods of heightened tensions.
Consequently, we confer the EM volatility landscape in ‘Opportunities in EM FX Options’ and suggest that buying a USDKRW double no-touch is now compelling: Fading North Korea risk premium. Selling volatility outright with unbounded risk is unfavourable given unquantifiable price action in the event of a tail risk outcome. Owning volatility is expensive, and we favour currency pairs with lower absolute vol and less extended skew (such as TWD and CNH) to hedge North Korea risk.
