FxWirePro: Relative Value options structures to monetizing sterling’s rattling

Away from the systemic focus on Treasury yields and the broad dollar, one idiosyncratic G10 FX development in recent weeks is the increased political noise around GBP.

Our macro strategists noted last week that the government’s Brexit strategy is paralyzed with only ten months until the UK is due to leave the EU and that PM May is under pressure from advocates of a harder Brexit within her cabinet as well as legislative pressure from advocates of a softer Brexit within parliament. The issue of splitting the cabinet is customs policy (the PM favors a customs ‘partnership’ that Brexiteers fear is a back-door to the continued customs union and EEA membership).

Customs policy is also central to resolving the Irish border issue and therefore crucial to whether the withdrawal and transitional arrangements can be finalized with the EU by the autumn.

The lead-up to the EU summit on June 28-29 could be politically quite fraught and hence a source of volatility for GBP, especially if the government brings a vote on the EU withdrawal bill to the House of Commons (GBP jilted at the policy altar again).

We propose two carry-efficient option structures below to benefit from the potential increase in GBP noise in coming weeks:

Zero-cost GBP put/CHF call vs USD put/CHF call switch: The macro G10 FX portfolio is positioned short GBPCHF, a directional view that marries deteriorating UK cyclical and Brexit unease with any potential upside from CHF appreciation resulting due to weaker equity markets and/or more forceful discounting of SNB policy normalization by rate markets now that the franc is no longer overvalued.

The motivation for mulling an option based expression of the view is that GBPCHF implied vols have been crushed by not only a broad compression of FX risk premia but also an increase in GBP vs. CHF via USD correlations towards historic highs over the past few months of dollar-centric price action in currency markets.

Realized vols are also performing at par with or even slightly better than short-dated implied vols, which had motivated a long GBPCHF vs short USDCHF spread suggestion last week. The choice of USDCHF as the funding leg of that RV is as important as long GBPCHF since realized vols in the pair have consistently disappointed and risk-reversals have been over-priced for USD puts for a while as an artifact of the market’s long memory of the franc de-peg.

A directional variant of this vol RV that can better suit many macro portfolios not given to active delta management is a zero-cost long GBP put/CHF call vs. short USD put/CHF call option switch (live options, not delta-hedged). Conceptually, such a spread expresses a short GBPUSD delta view.

The above chart is the diagrammatic representation of the empirical evidence of the efficacy of such spread structures for playing GBP weakness: equi-notional GBPCHF – USDCHF switches have out-delivered standalone GBP puts/USD calls since the onset of the GFC but at a fraction of the cost of the latter or even net premium credit at times.

A closer examination of monthly returns reveals that the option switch P/Ls have a beta 0.65-0.7 to that of standalone GBPUSD puts during periods of material GBP weakness, which is useful in scaling notional sizes relative to outright cable option purchases. Courtesy: JPM

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