FxWirePro: Quick Run Through On Relative Values In EUR/USD/JPY And USD/BRL Seagull

For EURUSD, the still slightly negative sign of the skew favors buying topside EUR via risk-reversals (41.7% allocation), an argument which at the same time suppresses the value of call spread structures (lowest allocation at 16.7%). If one believes possible near-term appreciation of the EUR to be capped, following the recent rally and without a structural change in terms of macroeconomic fundamentals landscape, seagulls (20.8%) would offer better value than call spreads. The long-term backtest (refer bottom part of 1st chart) supports the value in relying on the scorecard for choosing the directional structures, and in the current choice of seagulls as the second best performing instrument over long horizons.

J.P. Morgan Japan strategy team recently flagged more room for strategic JPY appreciation (Weak Yen Era to end due to COVID-19 impact) medium term, on the back of expectations of a renewed phase of deflation of Japan and of the economic impact of the COVID-19 crisis on global growth and oil prices, although they see little room for a sharp drop in USDJPY in the very near term. This observation, coupled with that from last week on the still elevated pricing of JPY skew and cheap vols leading to all-time lows in the pricing of digital puts (Yen vol distortion watch), resonates well with the result of the hedging scorecard which finds put-spreads and seagulls as the best instruments, with a capped max gain, for playing a moderate Yen appreciation over short time frames.

For USDJPY downside (refer top part of 1st chart) put-spreads are the best performing instrument in the long-run; the added-value from the dynamic selection is also confirmed, largely outperforming forwards. We also stress how the steep skew structure, making riskies the worst-performing instrument, recommends short skew constructs like put spreads, in line with the result of the backtest. 

Playing the USD-lower theme in EM is supported by the favorable rates differentials, still cheap EM valuations with respect to other asset classes that have enjoyed more sustained recovery, although the sensitivity of EM Carry plays to local idiosyncrasies, global sentiment and (indeed) USD directionality requires some care when structuring the trades. We have noted earlier on the relative expensiveness of EM vols and skews vs. G10 ones. Despite the large move in spot, a more granular analysis finds an even bigger dislocation on the pricing of the USDBRL skew, based on a linear relationship comparing changes of riskies pricing vs. spot moves, both measured over 3M horizons (Exhibit 3, bottom). Keeping in mind that the country, and the Latam region in general, is still experiencing the most acute phase of the health crisis, lagging Europe by 1-2 months, and the fact that the currency has experienced a 25% vs USD ytd, the medium-term fundamentals remain better supportive for Brazil than other EM countries with large fiscal deficits and/or weak BoP position. That said, rather than entering an outright short risk-reversal trade, fully exposed both in spot and vol terms to an inversion in market sentiment, we add a long OTM USD call / BRL put to the 25-delta risk reversals for capping the maximum loss the structure can suffer. 

For all structures below, we assume no delta-hedging to be enforced. Consider:

Long 3m bullish seagull on EURUSD, long ATM EUR call / USD put, short 25-delta EUR call / USD put, short 25-delta EUR put / USD call @ EUR .36% (spot ref. 1.1330, strikes 1.1359, 1.1638, 1.1107).

Long ATM / short 25-delta 3M USD put / JPY call spread @ USD 0.66% (spot ref. 109.00, strikes 108.79/106.21) .

Long 3M USDBRL 25delta USD put / BRL call, short a 25delta/10delta USD call / BRL put spread @ USD 0.2% (spot ref. 5.1009, strikes 4.842/5.508/6.052). Courtesy: JPM