FxWirePro: Striking RR propositions in EUR/Scandis and EUR/CEE

The rating agency Moody’s fears that the conflict between the Polish government and the European Commission might strain confidence among international investors and thus have a negative effect on the credit outlook.

However, this view had little effect on the zloty, which is no surprise. Similar experiences in Hungary illustrate that a higher risk premium will eventually be priced out again when an escalation of the conflict fails to materialize.

We, therefore, assume for now that it will be mainly the monetary policy outlook that will dominate in EURPLN.

As expected yesterday’s inflation data confirmed that inflation pressure in Poland is easing and that rate hikes will not be an issue for the foreseeable future - thus not providing support for PLN either.

EUR-crosses of satellite European currencies such as EUR/Scandis and EUR/CEE are liable to decline during Euro-uptrends, and their risk-reversals to accordingly underperform.

The cumulative returns (vol pts.) from selling 3M 25D vega-neutral risk reversals in EURPLN (selling EUR calls vs buying EUR puts). Options delta-hedged daily using smile forward deltas and options expiry matched forwards and rolled into fresh strikes every 3m. The P/L stream for every currency pair is the average of three individual return time series corresponding to initiation at t=0, t=1-m and t=2m to smooth out distortions that might arise from the choice of a single inception date for the simulation. No transaction costs.

This has indeed been the trend in recent weeks judging from option returns in the above table, and we have exploited this phenomenon in recent weeks via RV constructs involving long USD/Europe vs short EUR cross long/short vol pair trades (the macro portfolio is running an EUR call/USD put – EUR call/NOK put switch along these lines).

Yet EURPLN risk-reversals have proven relatively resilient given the political noise around the judicial reforms in Poland and have barely budged from the 1.2-1.4 range that 3M 25D riskies have traded within all year even as EURUSD riskies have re-priced dramatically for EUR calls.

JPM’s analysts expect Poland's solid macro fundamentals to trump short-term political volatility and insulate the country against negative credit actions, which is supportive of fading any risk premium built into EUR calls/PLN puts in the current milieu of cyclical Euro strength; indeed, it is comforting to note that systematically selling EURPLN risk-reversals has been a high Sharpe Ratio trade since the GFC (refer above chart).