FxWirePro: Append optionality to KRW on BoK’s dovish approach to mitigate FX risks

The latest data releases for South Korea continue to point to a strong economy led by exports but with inflation contained. The final reading for Q3 GDP was revised up slightly to 3.8% YoY from 3.6% previously. This puts it on course to expand by 3.3% this year and continuing in 2018 by another 3.3%. One key driver is the strong external environment with November exports rising nearly 10% YoY.

At the same time, November inflation receded to 1.3% YoY after averaging above the official target of 2% in the first nine months of the year. Lower fuel and housing prices were key factors behind the decline but given higher oil prices of late, it should restrain the downside.

Overall, the moderation in inflation is consistent with Bank of Korea’s (BoK) dovish hike this week by 25bp to 1.5%. We expect BoK to continue to normalize rates but at a gradual pace of two more rate hikes in 2018. Another factor that’s likely to influence the pace of rate normalization is the strong KRW. KRW is the strongest performing currency in Asia vs USD year-to-date, up 11%. For USDKRW, we look for consolidation near term between 1080 and 1120.

Option Trade Perspectives:

We emphasize buying USDKRW 1x1.5 call ratio spreads of near-month expiry, using strikes at 1090 /1110, indicative offer: 0.28% (vs 0.65% for the 1090 strike, spot ref: 1086.30).

Max leverage: 5 times of shorting the topside strike in 1.5 times the notional of the near leg provides a 55% discount to the 1090 call strike. A full reversal of the past two-month performance is required before there would be negative P&L.

Investors could also consider a 1x2 call ratio: the discount to 1090 call strike rises to around 70% and maximum leverage to 8.5x but the level at which the trade starts experiencing negative P&L is much lower (1128).

Low vol and moderately high skew Short-dated volatility parameters are conducive to position for a limited (2-4%) correction.

Vol: One-month implied volatility is at the lowest level since 2014 while the premium of implied over realized is at its two-year average.

Skew: Risk reversals have compressed alongside easing in North Korea tensions and the move lower in the spot, but selling topside is still the most advantageous versus regional peers.

The maximum loss is limited to the extent of the premium paid below 1090 and unlimited above 1144.