FxWirePro: Indian election risk premiums in USD/INR zero cost call spreads

The union elections of India are currently going on to constitute 17th parliament. The current polls are conducted in 7-phases and the results are going to be declared on 23rdof May. With only one month till the election results, we look for ways to leverage election pricing in expressing our macro analysts' downside INR bias. USDINR vol curve inversion is near the 2014 election levels (refer 1st chart) despite dramatically different base vol levels. 

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. 

We take a rough stab in this section, looking at the theoretical profitability of entering into FVA selling strategies (as an indicator of the repricing of election risk event) 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 are 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. A variety of exit dates are considered (between 1-month to 1-day ahead of the forward start) as a proxy of varying exit conditions.

2nd chart scatterplot maps various instances of entry fwd vols/ spot vols ratio vs short fwd vol P/Ls. The analysis suggests that forward vol/spot vol ratio of 1.4X marks the threshold beyond which election risk premium is too excessive. 

For USDINR the ratio is at 1.36. The level of inversion and the FVA/ATM ratio condition are supportive of using the election pricing to finance a directionally weaker INR calendar.

The macro analysts remain cautious on INR and see it grinding to 72.0 by the end of the summer and point out that INR FX valuations are not screening cheap, while the RBI’s easing path is likely to leave to central bank reluctant to see significant INR outperformance.

While the idea is to hold the short election tenor / long back tenor calendar trade past the expiry of the front tenor option, in the 3rd chart we look at the MTM for 40D vs. 40D/20D for various tenor combinations immediately following the election as a measure of downside risk. The highlighted represents the likely market conditions for spot and vol following the election (1.5 vol lower and USDINR weaker by about 1-2%). 

Historically, equivalent structures have performed well in prior elections as the structure was held past the front tenor expiry (refer 4thchart).

Hence, we recommend approximately zero cost, long 4M USDINR 71.0/72.8 call spread @7.15/7.5 vs 7.875ch financed by short 6wk 71.0 call, 8.825ch. Net pays @5/13bp USD, spot ref 69.94. Courtesy: JPM

Currency Strength Index: FxWirePro's hourly USD spot index is inching towards 14 levels (which is mildly bullish) while articulating (at 12:10 GMT). 

For more details on the index, please refer below weblink: http://www.fxwirepro.com/currencyindex