FxWirePro: Spot On TRY Risk Premium Via Short Vol And Deploy Directional Delta-Hedged Straddle Package

Turkish GDP expanded 0.40% in the third quarter of 2019 over the previous quarter. 

And the annual inflation rate increased to 10.56% in November 2019 from a near three-year low of 8.55% in the previous month, and slightly below market expectations of 11%.

While the Central Bank of Turkey slashed its one-week repo auction rate by another 75bps to 11.25 percent during its first policy meeting of 2020, defying market expectations of a 50bps cut. Policymakers have lowered rates for five consecutive times since July last year, bringing borrowing costs to the lowest level since May 2018, saying the inflation outlook continued to improve and inflation expectations sustained their wide-spread decline.

We remain of the view that the macro backdrop is tactically supportive of income harvesting where opportunities exist and we add to the model portfolio 6M delta-hedged MXN ratio spread and a hedged short vol in TRY. Within the current vol backdrop TRY stands out as an EM currency that packs in one of the largest risk premiums (refer 1st chart). 

Our macro analysts see TRY backdrop being near-term supportive of vol shorts but the question of extracting that risk premium without taking too much risk remains. The usual -3M/+12M calendars are not well supported at the current 4vols vol curve roll-down. 

An alternative is to construct a package consisting of a short straddle (delta-hedged) and hedge its left tail risk by owning non delta-hedged OTM vanilla call. This is a viable line of thinking in high-skew currency pairs where vol upticks are well correlated to directional returns, and TRY is a prime example of just such a currency.

The question of sizing of notionals between the delta-hedged straddle and the OTM vanilla call is somewhat arbitrary. An edge case would be to size the notional of the OTM vanilla call so that the vol carry from the short straddle exactly offsets the premium paid for the vanilla OTM call. Such notional sizing tends to be potent in protecting against high vol episodes but poorly retains short vol carry P/L. 

As a rough sweet spot between spending too much on the OTM calls and hedging too little, we settle on 25 delta strike and on using 1/3rd of the expected vol carry to finance the long vanilla calls.

For instance, for 100K / vega short straddle notional and for an expected vol carry P/L of, e, 2vol (calculated as the spread between implied and trailing realized vol) we spend 66K on the long OTM vanilla call. The second chart shows the vanilla call hedge to be effective in reducing the short vol left tail risk. The structure retains most of the short vol carry P/L. 

Consider shorts in 3M USDTRY delta-hedged straddle @10.1/10.7 vs. live (non-delta-hedged) long 25D call @12.575ch, 100K straddle vega notional (25mio / leg) vs. 120K spent on the 25D call (13m USD). Courtesy: JPM

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