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We have been carrying a long BRLJPY vs short USDBRL6M vol spread for a couple of months now with admittedly not much P/L to show for it despite timing entry just before the VIX shock; nonetheless, we believe this vol spread is the most parsimonious, transaction cost-effective expression of selling USDJPY vs USDBRL correlation and is a position we continue to like holding since technicals are still just as attractive as when we first recommended it.
The 1st chart shows that the implied vol spread at present is low both historically and compared to the general behavior of realized vols in less orderly FX markets. This is the case almost irrespective of strikes on the two surfaces, though, for choice, we have a slight preference for OTM BRL call strikes (i.e. the weak side of the risk-reversal for both pairs) where the vol differential is marginally tighter; for instance the vol differential for 6M 25D BRL call strikes is marked at 0.15 vol (mid) in 2nd chart.
For active/intra-day delta-hedgers, 1M ATMs should also be of interest where the vol spread is marked below zero, and where recent realized vol outperformance has been in excess of 2 vols (1-wk 2.2, 4-wk 2.5 based on hourly NDF samples).
Selling high-beta/EMFX vs JPY correlations from such near-zero levels is a convex trade in our view, since the fundamentally opposite risk polarities of the two currencies in question – one of which is a well-owned asset currency and the other a classic funding one – ensure that decorrelation is the norm rather than the exception for them irrespective of the state of the broad risk cycle, and violently so in a market crash; if so, the higher beta cross yen vol should always trade at a healthy premium to the low-beta USD vol, much like USD/EM risk-reversals persistently price at a premium for USD calls over USD puts to reflect the left tail risk of disruptively positive spot vol correlation.
That it is not the case at present is due to somewhat price-insensitive retail investor selling of BRLJPY vol for yield enhancement, and is an opportunity for more value-sensitive investors to pick up an easy-to-carry risk hedge on the cheap. Courtesy: JPM
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