Getting a Read on Mexico’s Election With Volatility Tea Leaves

(Bloomberg) -- Mexico’s much anticipated presidential election, which is ­scheduled for July 1, is drawing attention to the currency as well as the candidates.

If you happened to chart the term structure of foreign exchange volatility for the peso in mid-February, say, you might have noticed something interesting. With about five months to go before the voting, there was a pretty substantial peak at the six-month tenor—which, of course, lay on the other side of the election.

Why? Well, for one thing, there was a significant chance that Andrés Manuel Lopéz Obrador could win. AMLO, as the champion of the left is known, could alarm Mexican markets, potentially resulting in a weaker and more volatile peso.

Here are some tools you can use to assess the volatility dynamics around the election—or other events, for that matter. And if you have a view, these insights can potentially help you execute a more efficient directional trading strategy.

First, to take a look at the impact of the election on the volatility surface, run {XCRV USDMXN <GO>}. To chart 25-delta risk reversals, for example, click on the arrow under Curve and select 25 Delta Risk Reversals. In the field below that, select ATM Implied Volatilities and make sure USDMXN is the currency. (A signal of market sentiment, the risk reversal is the difference between the implied volatility of calls and puts at the same distance from the forward rate. Delta is the change in the value of an option relative to the change in the underlying exchange rate: In laymen’s terms, a 25-delta USD call is an option that has a 25 percent probability of finishing in the money at expiration.)

As of mid-February, both the risk reversal and at-the-money implied volatility rose sharply at the six-month point. The market expectation was that there will be significantly higher peso volatility around the election—and that a weakening of the peso would be more volatile than a strengthening of the currency.

To correctly price and value at-the-money (or ATM) FX options with expiry dates between standard pillar tenors (for example, options between the third- and six-month tenors), it may be necessary to add a volatility weight adjustment to the election date so the term structure of volatility will jump for options that span the July 1 date. To make this adjustment, run {USDMXN Curncy VCAL <GO>} for the Custom Volatility Calendars function. Use the drop-down in the upper left corner of the screen to select your own custom calendar.

The weight for USDMXN for your custom calendar is now shown in the center of the screen with the associated ATM volatility for the expiry date given that weight. Scroll down to the dates around the Sunday, July 1, election; you’ll find a smooth interpolation of the ATM volatility between the three-month and six-month tenors. That’s unrealistic. In fact, the market was pricing the 07/02/18 ATM vol at 15.9 as of mid-February, nearly a vol higher than where this option would be valued assuming a linear interpolation of implied volatility.

To calibrate the additional volatility weight with the market and add an event adjustment, click on the Weight Adjustments tab. Next click on One Time. In the window, set the date as 07/01/18, the Currency as MXN, the Adjust by Weight as 90, and the Description as Presidential Election. Hit Save. Click on the Daily Weights tab and scroll down again to the dates around the election. Now you’ll see the spread of variance more appropriately apportioned and the jump in implied volatility for options with expirations after the election. You can tweak this weight adjustment to calibrate with market pricing.

You can also automatically create a more realistic term structure of ATM-implied volatility by incorporating Bloomberg-suggested event adjustments. To do that, click on the Setting button, select OVDV/OVML Default Calendar, and use the drop-down menu to choose Bloomberg Recommended. To view the additional weights Bloomberg recommends, click on the gray Bloomberg Recommended tab.

Understanding these volatility dynamics can enable you to implement a directional trading strategy more efficiently. Let’s say you want to bet on a potential scenario in which AMLO wins and the peso significantly weakens initially after the election. To price up a USD call spread that would benefit from a weaker peso and also take advantage of the elevated risk reversal after the election to cheapen the overall structure, run {OVML CP MXN 07/05/2018 <GO>}. Click on the Views button on the red toolbar, select Layout, and click on Full Data to select it.

The default USD call spread that will come up will be a long ATM strike, discounted by selling a 25-delta call strike. If you want to choose specific strikes, simply enter what you want in those fields: Buy a 19.00 USD call, for example, and sell a 21.00 USD call. Note the price of this strategy is 2.55 percent of the USD notional. We’ve cheapened up the strategy by capping gains should the peso weaken further than 21 pesos per dollar. That discounts the strategy by 1.11 percent. You can isolate the savings from implied skew and smile, which can be thought of as how much the sensitivity to volatility changes with respect to changes in spot and volatility, respectively. To do that, compare the 2.55 percent to the T.V.—the theoretical value of the structure assuming the legs were priced with the ATM volatility. By selling the 21.00 USD call, we’ve cheapened the structure by 0.48 percent by selling skew and smile value. That wouldn’t be possible with a linear product such as a forward.

To view the P&L scenario analysis, click on the Scenario subtab and select Graph. The strategy will profit when the USDMXN spot rate trades above 19.55, but gains are capped should the spot rate go above 21.00 pesos per dollar.

Minde is an economics and FX market specialist at Bloomberg in New York.


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