FxWirePro: Fair interpretation and forecasting of Mexican peso in contemplation of underlying geopolitical and NAFTA concerns – Hedging Perspectives

Bullish USDMXN scenario: We could foresee the pair at 19.30 on a disordered NAFTA negotiation, political noise regarding elections and escalation of bilateral relations between Mexico and US.

Bearish USDMXN scenario: We could foresee the pair at 17 in 1Q’18 on a weaker USD overall, orderly NAFTA negotiations and low political noise locally and externally.

Mexican State and the Presidential election in July 2018 and Brazilian general elections in October 2018 have all been visibly priced into ZAR, MXN and BRL vol curves respectively. The pronounced surface distortions created by these event weights have prompted questions about whether they could be overpriced, especially in the case of MXN and BRL where votes are 10-12 months away.

Analyzing the fair value of election risk is a difficult task because of the small sample size of similar events to use as comparison templates, as well as due to significant differences in the circumstances surrounding each election cycle even within the same country.

Nevertheless, we take a rough stab in this section, basing our analysis on with five recent election events: Brexit referendum, French conditioned on the peak ex-ante premium of forward volatility spanning the event over pre-event spot volatility (expressed as the ratio of forward vol/spot vol).

FVAs considered being 1M in tenor with forward start date set 1-week before the event, which strikes a decent compromise between isolating event risk and ensuring realistic pricing (unlike say, 2-day FVAs starting 1-day before the event that is unrealistic). A variety of trade exit timing possibilities between 1m to 1-day ahead of the FVA forward start date are explored.

For each election event, we restrict the currency population to event-relevant ones only e.g. EUR crosses for French elections, MXN for US elections etc; the leap of faith is that sample-average conclusions are applicable more generally.

Hedging perspectives:

The peso has come a long way from its Trump lows and screens overbought and overvalued at current levels, leading our LatAm team to turn underweight recently.

The standout feature of the USDMXN vol surface to us is the cheapness of risk-reversals, both vis-à-vis ATM vols and particularly relative to the amount of carry in forwards that allows for carry efficient expressions of bearish directional views or tail risk hedges.

On a hedging grounds, we advocate buying debit put spreads of 1m tenors with upper strikes at around 19 levels, with OTM shorts at 17.50 levels.