FX Quant Strategy provides a quantitative overview of the currency market, including several valuation tools and monitors, focusing on the FX options market.
This week we recommend the FX option trade:- sell 2W GBP/USD straddle (skewed on the downside).
Implied FX volatilities have in general traded higher over the past few weeks and according to our volatility valuation model, not least GBP volatility look expensive. While the digital risk attached to GBP spot stemming from the UK's EU referendum on 23 June clearly explains the high risk premiums on GBP volatility beyond the three-week tenors, implied at-the-money volatility on the two-week tenors (expiry before referendum) for EUR/GBP and GBP/USD are also expensive, according to our valuation model.
We think selling two-week GBP/USD straddle looks attractive especially after the recent decline in GBP/USD spot following this week's repricing of Brexit risk in financial markets. In general, we see risks skewed on the downside for GBP/USD in coming weeks, due to election uncertainties and the risk of a hawkish FOMC at the 15 June meeting. As our short-term financial model also suggests that GBP/USD is still trading on the high side relative to an estimated fair value of 1.4373, we recommend skewing the straddle slightly on the downside.
Thus, we recommend selling 2W GBP/USD straddle with strike 1.4300. The strategy pays an upfront premium of 310 USD pips (indicatively, spot ref.: 1.4430) and is profitable if GBP/USD trades within the range of 1.3990-1.4610 at expiry on 16 June, which is the day after the next FOMC meeting.
The market is currently pricing in a 15bp rate increase in the US in July (60% probability of a 25bp increase in the Fed Funds rate). Using the betas derived from our short-term financial models, a 10bp increase in 2Y US swap interest rates would everything else being equal lead to a 1.6 figure decline in GBP/USD. Hence, given the already fairly hawkish pricing of the FOMC, we think the two-week sold straddle offers attractive risk-reward - even in the event of a hawkish FOMC.
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