FxWirePro: Tail risks fade, MXN gains and DCCS to hedge

The recent developments support currency gains but lingering risks should weigh down MXN toward year-end. Over the past weeks, data and news flow have been largely positive. US rhetoric around NAFTA renegotiation has turned more constructive, growth appears to be on a stronger footing than we thought, and fiscal consolidation—which will be aided by transfers from the central bank to the government worth 1.5% of GDP—is on its way.

All of the above could prevent a credit rating downgrade, which we continue to expect later this year.

No downgrade could provide a boost to the currency, which has already strengthened in part on higher carry-to-vol stemming from rate hikes and FX intervention. But the fact that NAFTA renegotiations might not be linear, and local political risks are likely to arise in 2H17 suggests MXN should lose some luster toward year-end.

Hedging Strategy:

After weekend’s correction in USDMXN from the highs of 19.9440 levels, the pair takes support at around 18.60 levels, but for now, more slumps seem to be likely to resume its previous bullish trend, the major uptrend still appears to be robust and likely to prolong further.

While ATM IVs of this pair is substantially spiking higher above 11.28% and 13.05% for 10d and 1m tenors which is conducive for the holders of the call options, but using the minor dips in this underlying pair writing narrowed tenor OTM calls would reduce the cost of hedging.

Thus, using any abrupt dips, initiate a diagonal credit call spread (DCCS) at net debit.

The execution: Initiate shorts in 1W (1%) in the money calls with positive theta, simultaneously, buy 1M at the money 0.51 delta call option. Establish this option strategy if USDMXN spot FX is either foreseen to be in sideways or spike up considerably over the next month.

On the flip side, dips momentarily but certainly not beyond your upper strikes in short run.