OTC Derivatives Trading
Summary: Event risk for the US election day has decreased over the last weeks while we still see interest to buy a bit longer dated options to cover for any delay in the election result. AUDJPY has a high correlation to the equity market and offer a cost-efficient way to hade for tail risk. We take a look at the vol pricing of the event and alternative ways to hedge long equity portfolios over the event.
Saxo Bank publishes two weekly FX Options Market Update reports covering changes and updates on the FX Options and FX Volatility market. They describe changes in FX volatility levels, risk premium and ideas how to trade based on these.
It is less than 1 month left to the US election and we have seen the risk premium for the event decrease over the last weeks to now trade at the lowest level since beginning of August. Some of the risk premium has been priced out of the market but most has moved further out on the curve as the market does not expect a firm result on 4th Nov due to the post voting. At the moment the market prefers to own the week after the election, or longer dates, over owning 4th of November. Popular dates to own have been 9 Nov, Monday after the election, or dates around 8 Dec which is the date states have until to resolve disputes over the result, including recounts.
Below table shows the current O/N Forward vol for the election day as of today and how it was priced on 3 Aug. The other column shows the corresponding implied move for the event, calculated as the cost of an O/N straddle.
USDMXN is the only currency pair which has a higher event vol now compared to back in August, this is partly due to the higher vol in general in MXN. USDMXN curve is currently trading 6-7 vol higher than in August.
The outcome of the 2016 election caused some exceptional volatility with big moves on the election night. Below table compare current expected ranges for this year’s election with the Hi/Lo and Open/Close ranges for the 2016 election day.
We had some very high volatility during the 2016 election night with very wide High/Low ranges but when the smoke cleared the Open/Close ranges came in more in line with how the marked had priced the event.
It is advisable to hedge your exposure before a big event like the election. Hedging with linear products could be costly with big swings in the underlying and it will limit to upside potential if the underlying would move higher. Hedging with options gives a higher degree of freedom for the investor and has the potential to fully participate if the market would move in a favorable direction.
Hedging equity exposures direct with equity options is of course the most efficient way but the high volatility makes buying options expensive. AUDJPY has a high correlation, ~70%, to the S&P and offer a low-cost alternative to hedge against tail risk in risk assets. Below we will look at two alternatives to hedge against a lower equity market after the election, a direct hedge in S&P or a more cost-efficient alternative using AUDJPY options as a hedge.
We have looked at 3% out of the money puts in S&P and AUDJPY with expiry 18 Dec. 3% OTM strike gives a good hedge compared to an at the money strike with significant reduced premium and 18 Dec expiry covers any eventual delay in the result. For a cheaper hedge buy a further out of the money strike or a shorter expiry. We would not choose too short expiry as we want to capture any delay in the result as well as any short-term trend in the market following the election result.
Buy 18 Dec AUDJPY 73.65 put (3% OTM)
Cost 85 pips/1.13%, vol 13.30
Buy Dec S&P 3315 put (3% OTM)
Cost 125.90 pips/3.68%, vol 27.80
Spot ref. 75.90 and 3419.50
S&P trades with a beta of 1.8 against AUDJPY, seen over the last year. This means we can expect to see 1.8 times larger moves in S&P than in AUDJPY. If S&P moves with 10%, AUDJPY is expected to move with 5.55%.
If you want to hedge a 1 mio USD exposure in S&P you then have to buy 1.8 mio USD equivalent of AUDJPY put. I.e. beta adjusted the AUDJPY option cost 2.03% (1.13*1.8) hedging the S&P exposure compared to hedging direct in S&P which would cost 3.68%.
If we compare the two options above and look at the pay-out for a move 10% lower in S&P, which would be equivalent to 5.55% move lower in AUDJPY. The S&P option would make 7.0% or 1.90 times the premium. The AUDJPY option, beta adjusted, would make 4.59% or 2.26 times the premium.You should be aware that in purchasing Foreign Exchange Options, your potential loss will be the amount of the premium paid for the option, plus any fees or transaction charges that are applicable, should the option not achieve its strike price on the expiry date
If you write an option, the risk involved is considerably higher than buying an option. You may be liable for margin to maintain your position and a loss may be sustained well in excess of the premium received.
By writing an option, you accept a legal obligation to purchase or sell the underlying asset if the option is exercised against you; however far the market price has moved away from the strike. If you already own the underlying asset that you have contracted to sell, your risk will be limited.
If you do not own the underlying asset the risk can be unlimited. Only experienced persons should contemplate writing uncovered options, then only after securing full detail of the applicable conditions and potential risk exposure.
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