FxWirePro: Deploy USD/CAD/COP Calendar Straddles for Delta-Hedge Amid Canadian-Saudi Diplomatic Spat

Canadian-Saudi diplomatic spat mostly geopolitical kabuki, limited impact on CAD. A seemingly spontaneous diplomatic spat over Canadian human rights criticisms of Saudi Arabia has rapidly escalated since it first broke out late last week, with news of Saudi divestment of official investment into Canada and a freeze on new trade, among other steps designed to communicate public displeasure. 

A quick back-of-the-envelope calculation suggests a range of roughly US$10-14bn worth of Canadian assets at risk of official selling, which at 4.6% of total daily FX turnover, 11.4% of spot FX turnover, 0.4% of equity market cap, 1.7% of government bonds outstanding, and 2.5% of annual imports, should have very limited sustained impact on the FX. 

And the spat, even if it persists, would have limited impact on the overall macroeconomic outlook given simply the small footprint of Saudi Arabia on Canada, compared to much more important and material economic counterparts in North America and other large developed and EM countries elsewhere. 

Instead, the biggest near-term risk to the Canadian macro outlook and CAD is still the ongoing discussions around NAFTA. 

Unwise to disregard USDCAD wedged between the prevailing storm-cloud of US trade policy escalation and an otherwise constructive cyclical outlook that is still warranting gradual rate hikes. Well, as stated previously in one of our post, at present, if we focus on the EM space, two currencies stand out as alluring for shorting vol: COP and TWD.

The rationale behind the former RV trade, a combination of positive vol Carry combined with modest exposure to risk, is still valid.

Similar arguments hold for selling optionality on COP, with 2M implied vol 50% above realized vol and 1 sigma above its past year average value. Compared to Asia, two political events in Latam (general elections in Mexico on July 1 and Brazil on October 1) have contributed to pushing vols higher, amongst other exogenous factors; choosing a 2M maturity allows avoiding the risk of being short-Gamma around the Brazilian elections date, while benefiting from vol levels which remain elevated.

Also, given its natural exposure to commodities and trade tensions, USDCAD works nicely as a hedge against the Carry generator, short-vol leg. Also, while this is not JP Morgan central scenario, a further resumption of the long US dollar trend, which has come to a halt over the past month, would not leave the long/short trade overly exposed: 1Y betas of the two currencies against the DXY index are comparable (60%), whereas betas of the two vols against the VXY Index show more sensitivity for CAD than for COP (50% vs 1%).

Despite the wide trading costs and some capacity constraints for trading the USDCOP leg in large size, the trade has performed well historically and over the past year and particularly so during periods where realized vol spread has been 3 vols above implied vol spread (where it stands currently). 

We advocate buying 2M USDCAD straddles @6.65/6.9, $35 million notionals/short 2M USDCOP straddles @12.25/13.5, $25 million notionals, keep both legs delta-hedged. Courtesy: JPM

Let’s glance at the FxWirePro’s Currency Strength Index: FxWirePro's hourly USD spot index is at -60 (which is bearish), hourly CAD spot index was at tad below -52 (highly bullish), while articulating at 11:28 GMT. For more details on the index, please refer below weblink:

http://www.fxwirepro.com/currencyindex