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There is merit in earning carry in risk efficient form, and we sell USDTRY 1Yx1Y FVAs hedged with a static vanilla ATM call.
USDTRY 1Yx1Y FVAs an appealing shorts, we are not chasing the drop in USD gamma lower; however, we identified the richness in 1Yx1Y USDTRY forward vols as a shorting opportunity. Given the sharp rally in USDTRY since November, the vol curve is in a very unusually inverted shape in front dates.
However, forward vols post 1Y remains elevated, and shorting FVAs at current levels has been generally profitable (refer above chart). In the 17 handle, it would take a vol spike above the highs of 2008-2009 for the short FVA to expire out-of-the-money at expiry.
To mitigate the risk of MTM losses, one can hedge out the implied short spot-vol correlation of the FVA by buying a 1Y USDTRY call. As we had noted previously, a market long USD has led to softer RRs, especially in longer dates (“A telegraphed USD rally makes longer-dated USD risk-reversals better value than short-dated ones”,). Indeed 1Y USDTRY RRs are cheap relative to forward vols, making vanilla hedges good value.
In particular, 1Y ATM calls, with $ notionals sized at 50 times the $ vol notional of the FVA – for instance: $5 mln vanilla notional for $100k FVA notional – have efficiently removed tail-risks over the past four years.
Initiate a short position hedged buy buying an ATM (DNS) call in 1:0.5 vega amounts, ahead of the MPC meeting, expecting the central bank to raise its corridor and thus stabilize FX markets.
The CBRT ended up under delivering in its monetary tightening (“the CBRT hikes less than market expectations, but vows to do more if needed”), and the resulting leg up in USDTRY proved the largest contributor to the PNL, just as was the case in late 2014 and mid-2016.
