FxWirePro: Expression of USD/BRL put/call calendars ahead of 2nd round of Brazilian politics

Brazil’s fiscal challenges are serious, and its politics does not seem conducive to a new reformist government with a legislative mandate taking over.

While the external risks seem contained, outside of the pressure that tighter global financial conditions could exert on domestic financial markets, and through these to household, corporate and government balance sheets.

The BCB should kick-off an aggressive monetary tightening cycle. How aggressive will depend on its ability to “get ahead of mounting inflationary pressures”.

We expect the gradual deterioration of macro-financial variables to continue, but the bottom line is Brazil looks like a train headed down the wrong track, but without any clear potential catalyst to trigger a derailing.

The eye popping 140 vol pricing of Brazil election in USDBRL overnights a few weeks ago has given way to a much more meager 2ndround O/N pricing of 53 vol currently, implying a breakeven spot move of 2% on the day. 

That however masks a nearly unprecedented degree of skew embedded in the probability distribution of USDBRL post-election spot (refer 1stand 2ndchart). In order to take advantage of the surface set-up, we scour through USDBRL put spreads (refer 3rdchart) that are well positioned for the anticipated limited BRL strength while being relatively insulated from from the inevitable vol rolldown after the event. 

Furthermore, adding a knockout higher in spot further cheapens the structure and fades the elevated rich risk reversal structure shown in the 1stchart. 1M USDBRL 3.65/3.55 put spread with 3.75 KO costs 64/84 vs 21bp USD choice, spot ref 3.70, 35% discount to an equivalent put spread structure without KO and 60% discount to an outright vanilla. 

As the likelihood of a surprise outcome is being quickly priced out of market and consensus expectations, it is worth considering positioning for a low-cost benign result via long BRL option structures that are also able to take advantage of the post-election vol rolldown. 

In the past, we have highlighted a low-cost calendar spread structure that is also well suited for the current setup. The rationale for a USD put/BRL put call calendar rests on: 

1) The expectation
that room for tactical real strength is fairly limited after the
surprisingly large 11% rally since late-September, and 

2) The post-event vol rolldown will hit short tenor structure harder. The vol curve structure is advantageous with 2wk USDBRL vols screening about 3vols too high relative to 1M vols (refer 4thchart). 2wk 6.65 USDBRL put (@18.95vol choice) vs. long 4wk 6.65/6.55 USDBRL put spread (@16.4/17.15vol indic vs. 15.1vol choice) costs 5/13bp USD, a fraction of the premium of buying 4wk put spread outright (78bp USD), spot ref 3.7010. Courtesy: JPM

Currency Strength Index: FxWirePro's hourly USD spot index is flashing at 95 (which is bullish), while articulating at 13:12 GMT. 

For more details on the index, please refer below weblink:

http://www.fxwirepro.com/currencyindex