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USDMXN approaching 20.0 target, and there’s a decreasing probability of a significant NAFTA-related rally in our view, given that further delays in negotiations may also muddy the outlook for an “in-principle agreement” considering the approaching elections in Mexico.
The risk-reward for long USDMXN is still attractive therefore in our view. The peso has certainly cheapened, yet we believe markets remain vulnerable to the uncertainty regarding changes in Government and Congress.
These risks have certainly been well-flagged, but candidates are more likely to harden their tone as we approach elections, rather than soften them. An interesting phenomenon is that spot continues to trade inversely correlated to ATM implied vol; this is a risk in our view as the carry-to-vol ratio for MXN makes it more attractive.
Bearish MXN scenarios: USDMXN at 21 on a disordered NAFTA negotiation, political noise regarding elections and escalation of bilateral relations between Mexico and the US.
Bullish MXN scenarios: USDMXN at 17.5 in 2Q’18 on orderly NAFTA negotiations and a reduction of political noise locally and externally. The analyzed profitability of trading FVAs around elections and found that the ratio of 1M FVAs (start date set at around 1 week before event risk) to ATM vols is a good metrics for estimating profitability. Namely, if the ratio is > 1.5 FVA is a sell and vice-versa FVA is a buy when the ratio is below 1.5.
At the current market, USDMXN 1M FVAs mid with the start date set to June 25 are priced more than 8 vols below the January cycle high and come at a modest 1.3X ATM vols (refer above chart) implying a good value in owning election vol to hedge the residual election risk. With overnight pricing commanding a punchy bid/offer, the equivalent pre-/post-calendar spreads (selling pre-event options and buying post-event options in order to isolate and capture sharp spot moves/realized volatility) are worth considering.
We recommend buying 12-week USDMXN ATMF straddles @19.75/16.25 financed by selling 8-week straddles. Courtesy: JPM
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