FxWirePro: A run through on buying 2M25D risk-reversals against shorting 9M35D USD puts/CNH calls

Hedging back-end USDCNH option shorts with front-end risk-reversals (equal USD notionals on all legs) does not detract from short vol returns while reducing drawdowns by 30%-40% Cum. P/Ls (bp USD) from i) selling 9M 35D USD puts/CNH calls, delta-hedged and ii) selling 9M 35D USD puts/CNH calls hedged with long 2M 25D risk reversals, equal notionals on all legs.

All options delta-hedged daily using smile forward deltas and option expiry matched forwards and rolled into fresh options monthly. No transaction costs.

Nonetheless, prudence demands that short FVA or FVA like option constructs require more protection than usual; we suggest buying 2M 25D  risk-reversals against selling 9M 35D USD puts/CNH calls(both legs delta-hedged and in equal notionals/leg) that take into account the cheapness of risk-reversals across the curve, especially adjusted for the level of carrying in forwards.

Selling the weak-side of the risk reversal (USD puts) on the back leg is both RV efficient and ‘safer’ than selling ATMs or OTM USD calls (market will move away from short strike in a blow-up, rendering the vol short less painful than would be the case with ATMs and particularly OTM USD calls) while owning front-end riskies offers cheap protection against a gamma shock.

The above chart explains that our proposed quasi-hedged structure does not detract from core short vega returns, but helps mitigate drawdowns to the tune of 30%-40% in a 2015 China-devaluation like the event.