FxWirePro: A glimpse through Latino and Mexican FX derivatives market ahead of election risks

Ever since the two major upsets during the turbulent election risk year that was 2016, FX option markets have been on a hair trigger around the issue of political event risk premium, as evidenced by the pronounced day-weights attached to general elections in the UK in June, New Zealand in September and most prominently the French presidential vote in April/May 2017.

In keeping with this trend, the December 2017 ANC party congress in South Africa, Mexican State and the Presidential election in July 2018 and Brazilian general elections in October 2018 have all been visibly priced into ZAR, MXN and BRL vol curves respectively.

The pronounced surface distortions created by these event weights have prompted questions about whether they could be overpriced, especially in the case of MXN and BRL where votes are 10-12 months away.

Analyzing the fair value of election risk is a difficult task because of the small sample size of similar events to use as comparison templates, as well as due to significant differences in the circumstances surrounding each election cycle even within the same country.

Nevertheless, we take a rough stab in this section, basing our analysis on with five recent election events: Brexit referendum, French profitability of entering into FVA selling strategies conditioned on the peak ex-ante premium of forward volatility spanning the event over pre-event spot volatility (expressed as the ratio of forward vol/spot vol).

FVAs considered being 1M in tenor with forward start date set 1-week before the event, which strikes a decent compromise between isolating event risk and ensuring realistic pricing (unlike say, 2-day FVAs starting 1-day before the event that is unrealistic). A variety of trade exit timing possibilities between 1-mo to 1-day ahead of the FVA forward start date are explored.

For each election event, it is restricted that the currency population to event-relevant ones only e.g. EUR crosses for French elections, MXN for US elections etc; the leap of faith is that sample-average conclusions are applicable more generally. Courtesy: JPM