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FxWirePro: Hedge Corona-Virus Epidemics Through FX Options Amid Low Vol Regime
Hedging coronavirus outbreak with FX options is not difficult given low vol. The rapid spread of the 2019 novel coronavirus (n-Cov) outbreak, with Wuhan (China) as Ground Zero, has raised fears of another SARS-like global epidemic. With the fatality rate running around 3% (vs. 10% in SARS) over 900 infected patients (vs. 8000 in SARS), the current market stance of heightened vigilance that demands some prudent risk trimming, but stops short of panic seems to be the appropriate one. The eventual seriousness / contagion potential of this new strain of virus will only be known in time, but one silver lining in the cloud (for FX option market participants) that has been the multi-year death- march lower in FX vol is that hedging adverse risk-market outcomes has rarely been easier. We highlight a few defensive option ideas that can slot into cyclically bullish macro portfolios:
USDCNH vol: USDCNH implied vol has dropped to post-2015 devaluation lows (refer 1st chart), and with China as the epicentre of the outbreak, is most obvious port of call as an Asian FX vol hedge against an escalation in coronavirus panic. The combination of depressed vol levels and early anxiety around a SARS-encore is reminiscent of period of short-lived calm ahead of the Phase-III (August) tariff escalation last year, when the option market remained stubbornly complacent even as news flow on the US/China trade front was turning less constructive at the margin. There is admittedly a reasonable premium over realized vol (1v), but this should not be a deterrent to buying vol in expiries beyond the very front-end (3M-6M) given their limited decay over short holding horizons and meaningful addition to CNH longs recently (basis the latest JPM EM investor survey) that can be squeezed out.
An additional, unrelated reason to consider CNH vol longs in the belly of the curve is that they price in minimal event risk for the Democratic primaries in the US Presidential election cycle, which has the potential to be market moving in the event of a Warren/Sanders nomination. Currently, the gap between forward and spot volatility in FVAs spanning the Democratic primary season (28 February to 24 July, from before Super Tuesday to after the Democratic convention) – a measure of event premium in FX options – is the narrowest in Asian currencies like CNH and TWD – refer 2nd chart).
This is as a little odd, since a hard-line approach to China has bipartisan acceptance in the US Congress by now, and the likelihood of renewed hostilities even under a different President – even if by non-Twitter means – cannot be ruled out. We are running a long CNH FVA in our portfolio.
Directional Asian FX hedges via purchased options: USDTWD calls screen as the best value in the region, but our preference is for JPY calls vs. SGD and KRW that have an established track record in stressed markets. The 3rd chart runs us through an exercise of ranking the universe of Asian currency pairs in terms of the ease of triggering maximum payout on identically geared (5x payout) “risk- off” digital options, based on a comparison of their spot-to- strike distance with the headroom available for spot to revisit the most bearish levels immediately after the levy of Phase III tariffs in August 2019. USDTWD calls float to the top of the list due to a combination of low vol base and favorable forward points and can be a suitable risk management overlay for portfolios heavily invested in long TWD as a core view for 2020. Courtesy: JPM