FxWirePro: Deploy directional USD/MXN 1:2 ratio call spreads and RKO calls on devaluation pressure and new governance

The Mexican peso has been under devaluation pressure since mid-October. The main reason is a decision by the newly elected President Andres Manuel Lopez Obrador (also known as AMLO), who would be taking office on 1stDecember.

Based on a referendum, he decided to cancel the construction of a new airport. The decision is problematic on the one hand because the survey was not official and only 1% of the electorate voted. On the other hand, the project is already running and the first construction works were in progress. With this decision, contracts are breached, so that there is considerable uncertainty as to whether one can still invest safely in Mexico at all.

For the market, this decision was surprising since AMLO, following its election as president on 1 July, initially struck a conciliatory tone, easing off investors’ concern about the shift to the left in Mexico. Therefore, the recent decision caused the peso to depreciate sharply against the USD. The pair is now trading well above the 20.00 level.

As an equivalent directional expression for those who want to stay short MXN peso 1*2 ratio USDMXN naked (not delta- hedged) call spreads have returned a Sharpe of 1.85 over the past 5-yrs. The trade has a large left tail risk, being exposed to large drops in the peso. USDMXN call RKOs are another expression worth considering, as they efficiently fade rich skews. The structure would benefit from well behaved and contained spot action, but most importantly it carries well defined downside risk (namely, the premium paid). 

Buy 2M USDMXN RKO call (20.70/22.00 strike/barrier) for 40bps USD (after 2% stealth), spot reference: 20.4855 levels. Courtesy: commerzbank

Currency Strength Index: FxWirePro's hourly USD spot index is showing 4 (which is neutral), while articulating at (13:34 GMT). For more details on the index, please refer below weblink:

http://www.fxwirepro.com/currencyindex