FxWirePro: Defensive Trade via Vega Exposure on Cheap CNH Risk Reversals

The news of the additional US tariffs also resulted in EM currencies/equities crumbling overnight. Apart from the Chinese readings, Asian manufacturing PMIs came in mixed to weaker. Short-end EMFX vols are ‘waking up’ again, with Chinese equities slumping in early trade on Friday.

Overall, expect USD-Asia upside to persist, especially with regional currencies now lacking the buffer of net portfolio inflows. Asian (govie and IRS) yields meanwhile may be expected to take the cue from the global core curves and explore the downside once again, flushing out any ambiguity witnessed immediately after the FOMC.

Spot gyrations generated strong gamma returns especially in Asia EM and x-JPY (refer 1st chart). How widespread and how impactful the trade escalation has been the best seen from the 1-week returns which are >90 percentile of YTD weekly returns for 26 out of 30 currencies in the Exhibit. We do not see a quick resolve and remain defensive though the current indications are that PBoC may want to bring back calm into FX. 

The PBoC activity on clamping down the CNY day-to-day spot moves over the last few sessions shows that the central bank might be comfortable with the current level of FX weakness. CNY vols came off from the recent multi-year highs, and the 6M is now back to sub-6vol handle. The US-China trade developments remain very fluid and we are bound to see a few more adverse episodes.

Cheap vega ownership: In anticipation of the vega tenors receiving more attention with the spot now under the watchful PBoC hand, we recommend using the favorable vol entry levels to add vega. 

Moreover, pricing of the CNH skew offers an attractive setup to own cheap CNH vol exposure directly via 6M 25D USDCNH puts (delta-hedged), i.e. to own the weak (or the "wrong") side of the risk- reversal. The structure provides long vega exposure but at smaller decay costs. The choice of the delta strike (25D to 35D) reflects a trade-off between deriving adequate discount vis-à-vis ATM vols and gamma/vega exposure. Based on the historical P/L time series in 2nd chart the "wrong" side OTM vega has been an efficient proxy for the CNH ATM straddles during adverse episodes. 

Consider: 6M or 9M USDCNH 25 delta puts @5.4/5.725 indic for 6M and @ 5.375/5.675 indic for 9M, delta hedged. Courtesy: JPM