An update on Brazil and an agnostic trade

Here’s USDBRL history of implied vol + skew, source Bloomberg. Now:

    1m vol @ 32.5% — 11 October.
    3m vol @ 25.7%.— 11 November
    6m vol @ 21.5% — 11 March 19

Highest in nearly 10 yrs.

USDBRL implied vol history – level and skew (risk reversals)

Why? Presidential elections on October 7th, October 28th.
– In 2014 we also had presidential elections and vols were much lower on the chart.

Possibilities:
– Market sees current indebtedness and fiscal path as much more dangerous than previously.
– Market sees chance of a populist president as too dangerous considering current starting point.
– Someone was really short that vol and is now stopping out.

Thoughts:
– Despite price not necessarily being mean reverting… in case Ciro Gomes is elected and it turns out he really is Hugo Chavez, volatility is mean reverting.
If vol gets too high participants of the such market just throw in the towel and abandon that market, that being of a stock, or a country’s currency or whatever good. As a group humans don’t like uncertainty and a single individual that does can’t make a market.
– USDBRL and USDBRL’s volatility are positively correlated.
Who issues liabilities in BRL with revenue in USD? I know of no one now. So hedges are to the upside, not the downside. USDBRL up > liabilities in BRL up -> stop losses to the upside -> self-fulfilling… the opposite when USDBRL is moving lower = USD liabilities lower in BRL terms = CFOs sleep well at night -> no need for hedges to upside.
– There’s uncertainty now, but after election, even if outcome is terrible, 1/ it will take time for us to REALLY know, 2/ if it is to be CERTAINLY bad, uncertainty drops anyway, despite what brazilians find out is that they are (hi!) screwed, 3/ odds are whoever wins election will at least try to fool the market, stating they’ll try to do what is right so the people who elected such crazy new president has a chance of living through his leadership. Brazil isn’t a dictatorship, at least not yet. Politicians are people and, like people, will try to keep what they got (power) at least for a while, before their lack of capacity to lead/transform is discovered by their electorate.

Idea:
– Shorting 6m USDBRL vol swaps: low (time) maintenance bet that USDBRL on average realizes less than 1.36%/day move from now to March 2019.
– Buying 1×2 or 1×1.5 USDBRL putspreads… strikes must be reasonably wide, say, 4-5% wide. If outcome is good (I’d say anyone other than Ciro or Haddad for now), USDBRL moves back lower, but vols collapse quickly. If Chavez wins, USDBRL goes to the moon and option trade expires worthless. Caveat here is that downside legs are cheaper than upside legs… smile is crooked now.

Spicy + complex:
– If one is still optimistic about Brazil one can buy EWZ risk reversals, by selling 3m or 6m ATM puts and buying out of the money calls or multiples of out of the money call spreads to get large convexity on the trade and also capitalizing on the high vol of the upper strike call of the call spread. EWZ 1m vols > 50% now.

I am optimistic about Brazil because if there’s no one like Chavez and the world doesn’t collapse sucking capital out of indebted Brazil we have huge runway:
– We’re sort of going through a balance sheet recession, like US/Europe in 2009-now.
– Low valuations (real yields very high, multiples are low)
– Lowest inflation (and cores) in decades
– Highest unemployment in decades to feed companies with cheap labor, allow for low inflation for longer
– Companies have reduced some of their debts, especially in USD terms (USD 119bln in 2015 to ~USD 100bln now)
– Companies have improved their operational leverage through cost cutting, firing
– Country now depends little of external financing to fund its debt (CA deficit -0.7% gdp, before effect of USDBRL from 3.3 to 4.15, FDI @ ~2.5-3% of GDP)
– Foreigners lows in domestic debt ownership.
– Govt is broke, so can’t spend – hence only fear of a extremely populist government
– Pensions + funds owns too little in equities.. it’s ALL bonds (actually, 32% equities in 2012.. now below 18% of their portfolio).

Risks:
– Global blow up
– Leftist leader wins AND delivers on irresponsibility.

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