FxWirePro: Low yielding vols lure long vega in USD/CHF and delta hedges

One sticking point is that 5Y USDCHF forwards is realizing 1.5-1.8 pts. below 5Y ATMs. This is not a direct impediment to vol buying since gamma contribution to long-expiry option P/Ls is minuscule, but the implied – realized spread is 1 vol high versus its long-run average as realized franc vol has been suppressed by SNB’s FX policy.

This gap used to be persistently negative in the pre-Lehman years under the influence of heavy vega-supplying flows in structured products from Swiss private banks.

That regime of inverted implied/realized premia has almost certainly changed for good since the 2008 carnage, but vol buyers nonetheless would prefer to see the spread compress further before dipping their toes into longs.

We are eyeing two option constructs to exploit the cheapness of long-dated CHF vol.

First, OTM USD calls/CHF puts can position one long vega, but with two added kickers: (a) 5Y 25D USD calls are priced 1.5 vols under USD puts on risk-reversals, which is nearing a historical low nearly as extreme as ATM vols (refer above chart), hence are discounted and incur no smile theta to own; and (b) long dollars is also the direction of positive carry – in fact, the highest net implied yields for any G10 USD pair – hence dollar bulls should find USD calls easy to carry. For investors who, like us, favor USDCHF directionally lower, buying delta-hedged options is the way to go.

Second, USD call/CHF put – EUR call/CHF put option spreads in ultra-long dates (10Y 25D CHF put strikes) are worth considering as a carry play. The delta direction is immune to a repeat of January ’15’s franc de-peg experience since there is no involvement with CHF calls, and is net positive a substantial amount of rate carry (10Y USDCHF forwards 34% below spot vs. 10Y EURCHF forwards only 9% below), which allows long/short 25D CHF put switches to be purchased for a minuscule premium (25 bp CHF on mids using equal CHF notionals); above chart shows that rarely has the price of such option switches been as low, and seldom their static carry as high as at present.

Pairing a short EURCHF call against a USDCHF one also neutralizes the problem of having a constructive directional CHF view to a large extent, which might otherwise be a hurdle to owning outright USDCHF calls. One could conceivably set-up similar spreads in shorter tenors, but pricing and carry characteristics significantly improve as one migrates to longer tenors.