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Yesterday a prestigious financial media agency reported that China would not renew the currency swap with South Korea, due to diplomatic tension over Seoul’s installment of a controversial US missile shield.
However, things have completely turned around this morning as South Korea officially announced that this currency swap has been extended by another three years, with the amount unchanged.
On the back of this news, KRW appreciated by 0.33% this morning.
On the flip side, as the Federal Reserve ponders the transitional nature or otherwise of low inflation, the dollar is finding itself, yet again, with fading real yield support. There is enough growth and expectations about Fed tightening in 2018 are sufficiently modest that a sharp fall is unlikely, but the September dollar bounce has fizzled out, while higher-yielding currencies are looking perkier again.
We’ve been neutral on KRW as the rising geostrategic tensions on the Korean peninsula has certainly impacted domestic market sentiment. The USDKRW cross is 2% above the year-to-date lows, the KOSPI equity index is down over 3% in the past month (with foreign investors pulling USD3.3bn from local stocks since late July), and 5yr CDS is up 10bps over the same period.
However, these moves are very much within the historical norms in terms of periods of heightened tensions.
Consequently, we confer the EM volatility landscape in ‘Opportunities in EM FX Options’ and suggest that buying a USDKRW double no-touch is now compelling: Fading North Korea risk premium. Selling volatility outright with unbounded risk is unfavorable given unquantifiable price action in the event of a tail risk outcome. Owning volatility is expensive, and we favor currency pairs with lower absolute vol and less extended skew (such as TWD and CNH) to hedge North Korea risk.
The sensitivity of average EM implied vol and risk reversals to changes in underlying spot rates remains depressed ( the exception being KRW).
Skew: KRW has high skew and high skew-to-vol (call spreads offer attractive discounting for dollar bullish views) – these metrics are very low in CNH, SGD, and TWD.
Convexity: Butterflies are expensive in KRW but cheap in CNH based on one-year ranges.
