• FxWirePro: hedge USD/ZAR’s upside risks via debit call spreads as S&P and fitch downgrades South African credits to junk

    Source: FxWire Pro - Ratings / 17 Apr 2017 06:33:14   America/New_York

    The South African economy still faces persistent headwinds. We forecast a growth rate of only 0.8% for 2017. In 2018, growth should not come in significantly higher; we see it at 1.5%.

    However, the focus is currently on the consequences of the unpredictable politics. With the latest cabinet reshuffle, South Africa’s already tight fiscal policy situation looks set to deteriorate further as President Jacob Zuma has now largely been given free rein.

    Against this backdrop, the rating agencies Standard & Poor’s and Fitch have downgraded South Africa’s credit rating to junk. 

    This should exert strong pressure on the rand because some investors are now forced to reduce their South African exposure. The generally favorable market environment for emerging markets and a forward-looking, proactive central bank should be able to prevent the rand from crashing, though.

    Should the rand depreciate strongly we would expect the central bank to intervene. Besides interventions in the case of excessive volatility, we would then not rule out rate hikes to support the currency.

    Option Strategic Recommendation:

    Overall, ZAR’s major as well as short term trend has been bearish bias, thus, at spot ref: 13.2717 we recommend below option trades.

    While the changed political landscape suggests the medium-term picture is shifting more positive, we remain tactically bearish ZAR.

    Subsequently, on the option trade front among EMFX, we recommend positioning longs in USDZAR as the South African significantly overshooting fundamentals.

    Long USDZAR portfolios that make us buying USD vols all the more appealing. Instead of naked vanilla call form we suggest call spread structure for the 2M horizon, optimizing strikes for leverage.

    In USDZAR, the 1M-2M ATM spread is below average at +0.75, as 1M vols had remained relatively anchored and never softened significantly.

    Therefore, the premium for owning US elections risk isn't punitive, and the short leg further mitigates the cost of gamma.

    The above table explains how does the call spread is ordered in decreasing values of max payout/cost.

    We find that skews aren’t steep enough vs ATM to allow for a wide range of strikes to be efficient. In order to ensure more than 50% discount to the outright vanilla, and a max payout/cost higher than 3.5:1, one needs to choose a combination of long 40D vs 25D.

    Especially EURZAR is another interesting pair to consider as a Euro-contagion hedge given that implied vols there have collapsed to 2-years lows at par with delivered, and as one of the few currencies to withstand the gamma carnage this month.

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