FxWirePro: NAFTA hedging – Gamma spreads for LatAm FX pairs

Long MXN vs. short BRL gamma spread as a NAFTA-disruption hedge: While the ongoing round 6 of the NAFTA talks has been fairly surprise-free, we remain wary about the possibility of late-hour disagreements on contentious negotiation issues, especially against the political backdrop of the Mexican Presidential election in the summer and recently revived US protectionist rhetoric that could worsen NAFTA sentiment.

The 6th round of the NAFTA negotiations comes to an end in Montreal today. While CAD traders had so far paid little attention to the progress of the negotiations this is likely to have changed following the last meeting of the Bank of Canada (BoC).

By now everyone is likely to have realized that the future of NAFTA would not only have an enormous effect on the Canadian economic outlook but that even the continued uncertainty of the matter might affect the BoC’s rate hike path.

An uncertainty that might continue for some time yet - according to a report, industry representatives and people close to the negotiations assume that the negotiations might be extended beyond the current deadline of 31st March maybe even into the next year. In Montreal, no significant progress has been made on any of the critical issues.

We expect more details from the statement at the end of this negotiation round. We assume that CAD will react much more sensitively to NAFTA headlines than it did in the past.

Hence, ahead of uncertainty NAFTA and trade tensions. Accordingly, MXN is anticipated to strengthen to 18.40 with improvement in NAFTA sentiment.

It is concluded that MXN gamma was a tad rich, and we preferred to hedge NAFTA risk via better priced if less potentially explosive CAD options.

As 1M ATMs have moderated from intra-week highs, owning MXN gamma is looking like an attractive hedge against NAFTA disruptions, especially funded by selling BRL vol which we argue above is worth earning theta in after the Lula decision; an MXN-BRL vol spread enjoys more than 2 vol pts of ex-ante implied – realized vol carry, and stands a decent chance of delivering solid returns even if USDMXN were to fall sharply towards 18.0 in the event of a positive negotiation outcome. It is comforting that outside of the carwash BRL plunge in May of 2017, the USDMXN – USDBRL vol spread delivered positive returns both during global vol flare-ups and in the interim quiet periods (Figure 8), though admittedly peso itself was under stress during 2015-16.

We enter a 1M USDMXN vs USDBRL straddle spread; liquidity permitting, investors could also consider selling EURBRL vols in lieu of USDBRL that trade nearly at par on implieds, but where broad USD centric currency moves are likely to keep realized vols better contained.

Buy 1M USDMXN vs. sell USDBRL ATM @12.5 choice vs 11.5/12, in equal vega notional. Courtesy: JPM