Forex Investment and Currency Trading

With the current market risk aversion still in place, and the year end outlook for EM currencies mixed at best, the risk of dollar strength has remained priced into EM volatility surfaces. The USD/BRL implied volatility surface still indicates risk aversion priced in through historically high risk reversal levels. Thin markets and possible trade unwinds point to a higher spot USD/BRL as well to the end of 2008/early 2009. Graphs below show USD/BRL spot at a significant point, as well as the 1-month 25 delta risk reversal staying within a steep upward channel.

Because of the skew, taking advantage of this view is not inexpensive. Outright purchase of vanilla options, which yield unlimited upside in a high vol environment, combined with the upward sloping forward points, makes the cost of options look unattractive.

Instead, USD Call spreads, either in vanilla or with a combination of an RKI in 3-month expiry are more cost effective by selling off the extreme upside of the skew. Below are two examples of these trades and how they compare to the vanilla pricing.

USD/BRL
Current Market Parameters

• Spot Reference 2.1950
• 3m NDF Reference 2.2600
• 3m ATMF Implied Volatility 37%
• 3m 25 Delta Risk Reversal 18.5%

Indicative Option Pricing

• 3-month ATMF USD Call/ BRL Put 2.2600 strike costs 7.355%$

3-month USD Call/BRL Put Spread

• Strikes 2.30/2.50 in even USD amounts costs 2.50%$
• Payout Ratio Up to Max 3.6 to 1

3-month USD Call/BRL Put Spread with RKI

• Strikes 2.30 Vanilla against 2.45 with a RKI 2.55 in even USD amounts costs 2.20%$
• Payout Ratio up to Max 5 to 1 if does not trigger, and 3.10 to 1 if it does trigger

Spot USD/BRL

1M Delta Risk Reversal in USD/BRL