FxWirePro: Zero-cost conditional EUR crash hedges

The flipside of greater mainstream acceptance of the European recovery theme is that attention to left tail EUR risks has now severely diminished. While it doubtlessly hooves investors to position for the baseline view, this complacency also makes it a good time to start searching for zero-cost ways of hedging against a Le Pen upset, the view being that the probability of a shock is too low to commit premium but the fallout devastating enough to warrant owning some just-in-case protection.

We propose buying conditional EUR bearish exposure via long/short pairs of EUR puts. Conditional trades require a pair of reasonably correlated assets whose expected relative returns are misestimated by their option prices. EUR-crosses offer a rich universe to scan for such opportunities since they vary widely in their responsiveness to continental shocks which increases the odds of finding jointly-mispriced pairs.

The above chart illustrates the point by plotting the historical spot return betas of EUR pairs to EURUSD during months of sharp Euro declines (defined as monthly EURUSD return <= -5%, constituting ~ a 2-sigma fall). While concerted Euro-weakness can and does drag most of the bloc lower (mostly positive EUR betas), a handful of currencies – EURHUF, EURRUB, EURPLN, EURNZD and EURAUD –have bucked the trend. EUR/Asia crosses on the other hand (EURCNY, EURTWD, EURSGD) tend to adhere to the EURUSD trend most closely due to the managed, low volatility nature of Asian currencies. EURJPY demonstrates the highest beta to Euro-turmoil for the obvious reason that both legs of the cross pull in the same direction during stress.

How do relative option prices stack up for pairs at opposite ends of the Euro-elasticity scale? One simple comparison is via net prices of long/short pair trades of EUR puts with identical % OTMS strikes on both legs; the above nutshell does so for various combinations of currencies, restricting EUR put longs to the subset of (EURUSD, EURJPY, EURGBP, EURINR, EURSGD, EURCNH and EURTWD) and shorts to a narrow group of (EURPLN, EURHUF, EURAUD, EURNZD).

Zero/sub-zero net option premia in the table are of obvious interest, but we can also live with low positive prices where strikes on the short leg require only minor tweaking to produce zero-cost outcomes.

The following strike us as well-priced zero-cost combinations:

Buy an equally-weighted basket of EUR puts/SGD calls, EUR puts/CNH calls and EUR puts/INR calls, 2M 5% OTMS strikes on all legs vs. sell 2M 5% OTMS EUR puts/AUD calls.

Buy an equally-weighted basket of EUR puts/USD calls and EUR puts/GBP calls, 2M 5% OTMS strikes on both legs vs. sell 2M 3.5% OTMS EUR puts/AUD calls EUR/AUD is the favored short leg despite EURNZD screening as a better-priced option sale in the above nutshell for the sole reason that AUD spec positions (basis IMMs) are materially positive while NZD positions are net short, hence AUD offers greater de-risking potential.