Part of this activity can be explained by the increasing migration of trading away from the onshore non-deliverable renminbi market (CNY) to the offshore deliverable market (CNH) in Hong Kong. Since the deliverable market was set up last July, investors have flocked to it because of the positive carry compared to the CNY market. Many also feel they can get more bang for their buck, say traders. Market activity has picked up as more market makers have come into the market in both CNH spot and options and more clients have opened nostro accounts.
As the options market has developed, an interesting anomaly has offered an opportunity for investors to play the China theme of rising inflation and more tolerance from Chinese authorities to let the currency appreciate - while also getting exposure to the general dollar weakness. Due to the deep skew on the downside of the currency pair, traders can construct very attractive China call spreads, dollar put spreads. For instance, traders can buy a 35 delta China call and then sell a 15 delta China call spread to the same maturity and receive a pick up in volatility terms, reducing the overall cost of the option structure. That is because one-year 35-delta volatility is priced at 4% and one-year 15 delta calls (which the customer is selling) are priced at 4.5% (see chart). This has provided a cheap way for investors to lock in returns on the gradually appreciating currency.
Why the anomaly? Traders say that it is mostly a function of supply and demand dynamics, and in particular the heavy supply around at-the-money vols. This has pushed higher delta options lower, whilst 15 delta options on the downside have conversely seen good buying from hedge funds, another CNH market maker says. He adds that there is probably a premium built into the downside in CNH due to the risk of a one-off revaluation in renminbi.
There has also been good interest in buying vanilla CNH calls, dollar puts, on the general theme of dollar weakness. In that regard, CNH offers greater potential for return than CNY, notes one currency strategist. It is less managed than CNY and will always trade within a + or – 0.5% band around the fixing that is calculated daily by SAFE. Whilst the CNH is unlikely to diverge drastically from the onshore currency, technically speaking it is a freely floating deliverable currency in Hong Kong. Thus buying into both the China inflation and appreciation story and dollar weakness means that CNH vols look pretty cheap, says a Hong Kong-based market maker. “It’s a different way to play the broad dollar weakness, but at the same time play the China theme, with more tolerance from the Chinese authorities to let the currency appreciate.” Three month CNH vols at 2.6% look pretty low compared to 13% for three-month euro vol.
| CNH option skew |
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| Blue line: 15 delta call; Green line: 35 delta call Source: Bloomberg data |