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In recent months, the linkage between broad USD strength and CNY depreciation has increased. During every incidence of strengthening dollar in the past year, the PBoC chose to go with the tide and let the renminbi depreciate against the dollar, but it largely resisted any further depreciation of the renminbi against the trade-weighted basket. This also has been the case since 8 November. The PBoC may continue this approach at least until Trump’s inauguration on 20 January 2017.
Upward momentum in the dollar should be maintained through H1’2017. Our in-house forecasts for the G10 currencies imply that the dollar index would rise close to 106 in Q1’17, up another 4% from the current level. If the pace of appreciation slows, or possibly reverses slightly, it shouldn’t have an undue influence on the upward trend in the USDCNY if rate differentials are still widening out.
Well, On account of PBoC stubborn regulations on CNY exchange rate, we devise option strategies to mitigate the further upside risks of USDCNY.
Exorbitant option affair (USDCNH calls/one-touches): For a 1-year ATMF USDCNH call to payout, spot needs to trade above 7.30. A 25d delta option (strike at 7.55) requires spot FX to trade above 7.65. To get a reasonable pay-off (5-1) in a 1y USDCNH one-touch requires a barrier level of 8.0.
Economical option affair (USDCNH call spreads (less expensive)): Shorting topside optionality provides a significant cost reduction over vanilla calls. A 1y2m/25d call spread (7.08/7.55 strikes) costs 1.70%, a 45% cost reduction over the vanilla call (3.12%). However, the maximum leverage (2.7 to 1) is limited.
Costless option affair (Seagull (cheap and good risk-return)): A seagull structure is a call spread combined with selling a downside strike. The structural richness of implied volatility over realized volatility argues for short volatility structures. Additionally, selling the downside strike put is appealing because there are few fundamental reasons for the CNH to trade meaningfully stronger over the next year.
