FxWirePro: China seems risky venture, Escalating risk premium and rationale hedging amid North Korean potential threats

Escalating risk premium: The rise in geostrategic tensions on the Korean peninsula has certainly impacted domestic market sentiment. The risk aversion around this issue can still rise further and broaden. For EM Asia markets the most immediate channel this is likely to be evident is via equity and currency markets.

North Korea discerns how to push the limits but one would think they are smart enough to not cross a real "red line" that would ensure the regimes destruction.

As such, a full blown conflict remains a very low possibility and fading recent price action will be viable at some point. But tensions have escalated recently, and while financial markets and the KRW have been imperious to previous bouts of North Korea uncertainty, risk premium is rising.

China unlikely to be a safe haven: Bearish CNY is attributed given,

1) One more Fed hike by the end of this year, thus driving a higher DXY and sell-off in major non-USD currencies;

2) The downside risk in China’s growth emerges, raising a worry on growth slowdown and capital outflows;

3) Unexpected weakness in Euro or JPY, pushing a board Asian currency weakness vs dollar.

Thud, a logical hedge would be long USDKRW or long JPYKRW, but won options are pricey with volatility spiking and risk reversals at the top end of the 3yr range. If tensions remain high risk premium could spread to neighbours in North Asia.

In the recent past, we’ve recommended a longs in USDTWD down-and-out call structure.  As stated above, as China seems unlikely to be safe haven asset if things get out of control and with volatility and skew low, coupled with positioning that was increasingly short dollars, makes it a good candidate for a hedge, especially for portfolios that are short dollars and long carry such as our own.

Well, overall, a global risk-off sentiment would evidently affect EMFX more broadly, as the USD entices safe haven demand.