FxWirePro: BoE’s OBR cut expectation anchors IV pace in pounds OTC market - Hedge GBP/JPY downside risks using Vega ATM

12 September 2016, 14:53
Eko Rediantoro

1W and 2W ATM IVs of GBP crosses are rising dramatically in OTC markets, GBPJPY flashing more than 13% and 16% respectively ahead of this week’s monetary policy by Bank of England which is likely to stand pat but previous minutes hint on more easing on the cards.

Please have a glance on how implied volatilities skews of ATM puts of 1w and 2W are positively correlated to the OTM strikes on both calls and puts.

Data front, BoE on Thursday will be the major focus, with the inflation report seeing expected effects from Brexit on the real economy. Markets awaits further stimulus in the days to come, to price about 80% chance for another 25bp cut in Bank rate in upcoming future and some looking for more QE.  PMI of all services, manufacturing, and construction sectors have been improved this time according to the previous stimulus in BoE’s monetary policy.

In spot FX of GBPJPY, technically the pair has again drifted below EMAs and DMAs to the current 135.860 levels, what is weighing on the pounds slumps is that, the expectations on BoE monetary policy changes but the chances for lower interest rates in rest of the 2016 has grown up, above all lingering post Brexit formalities adding an extra pressure on sterlings depreciation.

Hence, we advocate the suitable option strategy to hedge the potential downside risks by using any small bounces through ITM shorts; this would have certainly ensured returns in the form of premiums. 

With the above technical and fundamental reasoning, we reckon to arrest potential downside risks of this pair by hedging through Put Ratio back Spread and accordingly, hedging framework was also suggested earlier, for now, it is reckoned that the underlying currency GBPJPY to make a large move on the downside.

So, stay firm with longs on 2 lots of 1M At-The-Money vega puts that would function effectively in higher IV times, long instruments to generate positive cash flows as underlying spot keeps declining, simultaneously, short 1 lot of OTM put with 1-week expiry.

The Vega would be at its maximum when the option is at ATM and declines exponentially as the option moves ITM or OTM owing to every tiny shift in IVs that will make no difference on the likelihood of an option far out-of-the-money expiring ITM. 

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