Tuesday, 14 January 2014

AUDNZD downside vol too expensive

Firstly, the AUDNZD has been very, very weak over the past year, unsurprisingly to a point, but now it seems a little extreme to me.

Below we can see the AUDNZD plotted against the AU 2 - NZ 2 year yield spread, and an accompanying model (AUDNZD=Bid,0= 1.202 + 0.1465 x (AU2YT=RRBid Yield,0-NZ2YT=RRBid Yield,0)) to show the divergence when related to price.

AUDNZD, rate spread (red) and model (purple)
Right now, with spot trading 1.07, we are clearly below where the rate spread would otherwise see us trade. over the course of the year the AUDNZD and rate spread has an R^2 of 85% suggesting that the theory the related FX to rates held strongly.

However right now, with the 2 year spread at 41 bps this prices in the AUDNZD at ~1.14 (+/- 1.5%), but it is clearly outside of this range by quite a lot. But when using this relationship to see why we are trading where we are, we see that the AUDNZD is pricing in a rate spread close to 100bps (more precisely 90bps +/-8), more than 50bps wider than current.

AUDNZD model with 90 bps and 125bps 2 year spreads as question
As we can see here, at 90 bps the model expects the AUDNZD to be trading at 1.0702 (pretty much spot)

Which in essence given the relative similarity of the AUD and NZD yield curves (in terms of shape) and given their equal base rates, means that the AUDNZD is trading currently with ~50 bps of RBNZ rate hikes built in. With the RBNZ unlikely to raise rates 50 bps in the coming 6 months then we have some potential opportunities. First comes from the idea, that if the RBNZ puts of the inevitable rates hikes a little longer, then Spot should, over time move towards the rate fair value in which case buying spot at 1.07 would be a good idea, and even if the RBNZ does hike, it currently prices in 50bps as we trade now so there is a clear buffer.

RBNZ OCR rate path

Furthermore though, when we consider the volatility smile for AUDNZD we can build some ideas.

1M, 3M, 6M vol smiles

We can see that, somewhat unsurprisingly there is a higher IV for puts vs. calls. And this would make sense in the 1Y duration as that is most likely when the rate spread between AU and NZ is at its widest. Above in the calculation, 125bps is put in to the calculation and returns a value of 1.02 for AUDNZD. So a move towards parity is technically possible, but for now, a long way off.

But for now, when considering the 6M duration, the 10 delta put is trading at 8.21 (mid) and the strike on the 10D put is around 1.01

AUDNZD and 10 delta 6M strikes
So we can see that the 10D strike is 1.01, and given that the market is already pricing in 50bps of hikes, it is unlikely that in 6M that it could trade 600 points lower and price in another 35-40 bps of hikes. And therefore, based on the level of IV and the probability that it manages to trade that low, it would make sense to consider selling these puts naked. The heightened level of IV for the puts on the short term makes this trade, at least from a risk:reward standing very attractive to me.

A way to increase the premium (and in turn, the amount you receive by selling) would be by also selling the 10D calls with a strike of 1.16. AUDNZD is unlikely to recover that far in 6m due to similarity in the RBA and RBNZ rate paths.

So entering a 6M 10D strangle would receive approx. 57 pips or just over 0.5%, not huge, but when factoring in the probability of a move outside of those bands in 6M it is a very strong chance this trade will perform.

conversely you could increase the delta ( bring the strikes closer to ATM) and hope to receive more in premium and you would, but also decrease the probability quite substantially that the AUDNZD trades outside the band. For a 20 delta 6M strangle you receive around 129 pips (1.25%) but the strikes are 1.03 and 1.13.

But like I said, this isn't about being in a strangle as much as it is about the downside puts being far too expensive up to 6 months, based on the idea that the AUDNZD is unlikely to move to a situation where it prices in a 125bps differential on the 2yr.

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