Peso rally cheapens cost of buying EM currency insurance

Political risk and tighter Federal Reserve policy loom as reasons for caution
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The Mexican peso’s (MXN) recent rally that has seen it strengthen below 20 to the US dollar (USD) has left option-derived implied volatility costs at relatively cheap levels.

These should be bought as a hedge against emerging market forex wobbles that may soon emerge, says Bank of America Merrill Lynch.

At the start of the week the bank recommended buying USD/MXN two-month volatility at an entry point of 13.2 per cent. It has a target of 16 per cent and a stop loss at 11 per cent.

“There are three potential risk sources that may lead emerging market currencies to underperform in the next couple of months, in our view,” says BofA, “French presidential elections in April and May, a Federal Reserve interest rate hike in March or May and a fiscal expansion in the US.”

Some of the underpricing of MXN volatility can be explained by the currency intervention programme recently announced by Bank of Mexico, BofA reckons.

“However, the intervention programme is not that big, in our view,” it says, noting that it represents at its maximum less than 20 per cent of a similar tool in use by Brazil’s central bank.

“We recommend buying two-month implied vols since the 2m3m slope is already quite steep. Two-month option contracts expire after France’s first-round election (but before the run-off) and after the Fed’s March FOMC meeting (but before May’s). Two-month options, however, provide enough time for expectations to shift as new information comes in.”

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