Bank of America Securities: US Election Risk Premium Overpriced in FX Markets, Potential for Carry Factor Performance Post-Election
In a recent note, analysts at Bank of America Securities highlighted that the risk premium in the foreign exchange markets ahead of the US election may be richly priced, especially in Asian emerging markets. Despite this, the bank believes that historical data shows that FX volatility may not realize enough to recoup the implied volatility premium around the election.
The median major FX pair has priced a 108% premium compared to the average of 2016 and 2020, as measured by the daily bounce in the 2-month implied volatility before the election. However, Bank of America Securities noted that EM Asia vols have not performed well in past US elections since 2012, leading them to favor fading implied volatility.
In a scenario where the election outcome is benign, the bank sees the spot trading broadly contained in a range of 6.85-7.30. Strikes at similar levels offer attractive premium opportunities to volatility sellers. The bank suggests that a short USD/CNH strangle could be an attractive strategy to fade the rich volatility premiums, with the risk being larger-than-expected fiscal stimulus in China generating significant USD/CNH swings.
At the time of writing, USD/CNH traded 0.5% lower at 7.0621.
Analysis:
In simple terms, Bank of America Securities believes that the risk premium in the foreign exchange markets ahead of the US election may be too high, especially in Asian emerging markets. This could mean that volatility in currency pairs may not be as significant as expected around the election. The bank suggests that there could be opportunities for investors to capitalize on this by selling volatility and potentially profiting from a strategy like a short USD/CNH strangle. However, there is a risk of unexpected events, such as fiscal stimulus in China, causing significant currency swings. It's essential for investors to carefully assess their risk tolerance and consider these factors when making investment decisions.