FxWirePro: Why and how do swaptions render tail risks of French polls and EUR/USD?

Well, the risks around the outcome of the Presidential French election needs to be analyzed in conjunction with the Parliamentary vote when you ponder over EURUSD risks. We believe that the political agenda of the newly elected President will be clearly driven by the capability of implementing his/her program with the parliamentary support.

Summarizing across the scenarios and our projections, we believe widener in swap spreads, FRA/OIS and EURUSD cross currency basis and long volatility will offer the most attractive hedge for the scenario of a Le Pen Presidency with supportive government and Parliament. However, given the limited probability but large impact of the tail risk we recommend building exposure either via conditional structures or where the risk/reward appear asymmetric relative to our baseline scenario.

In swap spread, we find it attractive to implement Bund bull swap spread widener. Given limited liquidity in the Jun17 options (expiry on 26th May) we recommend investors to hold the position on the longest maturity available in OTM structures but roll them further out. Ideally, the Jun17 options (expiring on 26th May 2016) would be the preferred expiry given the calendar of election (first round on 23rd April and second round on 7th May).

EURUSD cross currency basis in our view appears the least attractive way to position for funding stress under a Le Pen presidency with support from FN government and parliamentary majority. The current valuations in reds EURUSD cross currency basis are broadly in the middle of their range since QE started.

In vol, call skew in Bund options is currently not pricing the jump in implieds in a rally in Bund yields (discussed above).  That is, OTM calls are cheaper compared to ATM calls indicating that market is still pricing a decline in implied with yields.  Therefore, as a hedge towards the tail risk, we would prefer buying Bund gamma via outright OTM call options. 

For example, we recommend buying the 163 Apr Bund gammas via delta-hedged calls (implied vol around 3.8bp/day).  The 163 strike corresponds to 10Y German benchmark Bund yield at around 15bp.  Ideally, we would prefer options struck around 0% yield and with longer expiries (say the June options which expire in May).  However, on liquidity and gamma considerations we prefer the Apr Bund calls but note that we would roll these into May/June options as liquidity builds up in these contracts.

We not only like buying Apr Bund gamma outright but also versus selling maturity matched swaption gamma (Bund calls versus swaption receivers, delta-hedged).  As swap spread directionality intensifies, Bund gamma would outperform swaption gamma.  Historically, during the peripheral debt crisis episode of 2011, Bund/swaption implied vol spread had jumped to above 2bp/day.