FxWirePro: Fetch positive carry from shorting USD/CNH FX swap, when to protect upside risks via USD ATM call option and when to prefer NDFs

Economic activity continues to come in line with expectations and Chinese growth has stabilized.  Going deeper into the year, however, we see Chinese demand sequentially declining, thus putting pressure on industrial metals prices.

The PBoC set USDCNY fixing rate at 6.7940 this morning, below the 6.80 hurdle again. USDCNH fell to 6.78 after market opened.

However, different from the previous few sessions, the market saw little intervention from the agent banks this morning. That said, the strength of CNH this morning is largely a reflection of a broad USD softness.

For the time being, the market has significantly reduced their short CNY positions, while carry trade dominates the trading activities due to the extremely low volatility of CNH exchange rates.

Technically speaking, a carry trade should have been working if a trade gains a positive carry from shorting USDCNH FX swap while protecting the upside of USDCNH via entering a dollar call option. As long as the PBoC intends to maintain a stable CNY, this sort of carry trade will likely flourish.

Usually, the IVs (implied volatilities) in CNH is meager, but the economic difficulties in China but also the surprising institutional changes (e.g. to the fixing process) suggest that higher CNY volatility is likely to be the norm in the future.

Economize on premium-spend on carry trades using ratio call spreads that generate comparable returns to standard ATMF/ATMS option spreads but with lower premium outlay. USD put/Asia FX call ratios are well priced currently, with USDCNH the favored pick. However, if you’re skeptic on USDCNH vols (long option position needs higher IVs for significant change in Vega), alternatively, one can prefer other derivatives (preferably forwards).

The PBoC sets the mean of the acceptable USD-CNY fluctuation range on a daily basis - and following the recent introduction of a “counter-cyclical adjustment factor” completely at will. This mean rate is called “fixing” and is used to settle the NDF. Since 17.3.2014 the permissible fluctuation range by which the market rate can differ from the fixing is ±2%, so quite considerable.

Let’s suppose, the USD-based importer who wanted to hedge receivables worth CNY 1m payable in two months’ time on 29th March 2017 (settlement date 31st May 2017) would have chosen a CNY-NDF at a rate of 6.8375 had he based his choice on the price levels at the time. Initially, that would have been USD 560 cheaper than hedging with CNH forwards (6.7942 at the time).