FxWirePro: A Run Through of Vega Exposure on Vol Calendars and Cheap CNH Risk Reversals

The news of the additional US tariffs also resulted in EM currencies/equities crumbling overnight. Apart from the Chinese readings, Asian manufacturing PMIs came in mixed to weaker. Short-end EMFX vols are ‘waking up’ again, with Chinese equities slumping in early trade on Friday.

Overall, expect USD-Asia upside to persist, especially with regional currencies now lacking the buffer of net portfolio inflows. Asian (govie and IRS) yields meanwhile may be expected to take the cue from the global core curves and explore the downside once again, flushing out any ambiguity witnessed immediately after the FOMC.

Spot gyrations generated strong gamma returns especially in Asia EM and x-JPY (refer 1st chart). 'How widespread and how impactful the trade escalation has been' is the best seen from the 1-week returns which are >90 percentile of YTD weekly returns for 26 out of 30 currencies in the Exhibit. We do not see a quick resolve and remain defensive though the current indications are that PBoC may want to bring back calm into FX. 

The PBoC activity on clamping down the CNY day-to-day spot moves over the last few sessions shows that the central bank might be comfortable with the current level of FX weakness. CNY vols came off from the recent multi-year highs, and the 6M is now back to sub-6vol handle. The US-China trade developments remain very fluid and we are bound to see a few more adverse episodes.

Vol calendars: The front-back vol spread is another dislocation on the CNH vol surface. The CNH vol curve has inverted very sharply as front-end vols have risen alongside the CNY sell-off. The KRW and TWD vol surface show similar but less extreme setup. Under the PBoC spot management, CNY realized volatility is beginning to cool and the vol curve inversion should not be sustainable. That makes up for a risky but attractive opportunity for financing long vega bias by selling the front. It is well known that short front / long back tenor delta-hedged calendars have been systematically profitable in EMFX – and particularly so in Asia EM. The 2nd chart shows that short 3M / long 12M 25 delta puts vol calendar has fared well and displayed minimal drawdowns during May and the last week’s bout. Selling the front tenor downside instead of selling straddles provides a degree of safety as the short OTM CNH call option rapidly loses gamma as spot rallies. The JP Morgan’s "smart" model indicates TWD and CNH gamma to be the top-ranked sell candidate (refer 3rd chart). 

Consider: Short 3M USDCNH 25 delta put @5.65 ch vs long 12M 25 delta put @5.4/5.675 indicative, vega neutral or short 3M USDTWD 25 delta put @5.1 ch vs long 12M 25 delta put @5.2/5.55 ch, vega neutral. 

Cheap vega ownership: In anticipation of the vega tenors receiving more attention with the spot now under the watchful PBoC hand, we recommend using the favorable vol entry levels to add vega. 

Moreover, pricing of the CNH skew offers an attractive setup to own cheap CNH vol exposure directly via 6M 25D USDCNH puts (delta-hedged), i.e. to own the weak (or the "wrong") side of the risk- reversal. The structure provides long vega exposure but at smaller decay costs. The choice of the delta strike (25D to 35D) reflects a trade-off between deriving adequate discount vis-à-vis ATM vols and gamma/vega exposure. Based on the historical P/L time series in 2ndchart the "wrong" side OTM vega has been an efficient proxy for the CNH ATM straddles during adverse episodes. 

Consider: 6M or 9M USDCNH 25 delta puts @5.4/5.725 indicative for 6M and @ 5.375/5.675 indicative for 9M, delta hedged. Courtesy: JPM