Profiting from the Chinese yuan

BACKGROUND: While it still seems likely that China will eventually move towards a more flexible exchange rate system over time, a revaluation in the short term seems unlikely. This ‘later rather than sooner’ view of a revaluation of the Chinese yuan is driven by the People’s Bank of China’s (PBoC) current preoccupation with the tightening of credit expansion and the liberalisation of interest rates, rather than with foreign exchange reform. This was emphasised on March 24, when the PBoC raised the reserve requirement ratio of smaller banks by 50 basis points to 7.50% and upped its charges on loans to financial institutions from a flat rate to 63 basis points over the benchmark rate.

PROBLEM: How should derivatives traders, driven to make profits, make the most from this situation?

SOLUTION: With the renminbi still pegged to the US dollar for the time being, short-term implied volatility remains low (the one-month is only 1.50% and the six-month 5.50%), but increases across the curve out to the one-year mark, the point at which revaluation is expected to be once again back on the agenda.

Option strategies where the investor sells longer-dated volatility are therefore proving to be interesting trades, even if the back-end has come off considerably since the beginning of the year. Investors are also attracted by the steeply downward sloping nature of the non-deliverable forward (NDF) curve that allows those with a short US dollar, long renminbi exposure to obtain a cheap hedge. The reduced risk of revaluation in the short term has been reflected in the upward shifting of the whole NDF curve since the beginning of January 2004.

Many Asian-based investors, in an attempt to take advantage of this upward sloping volatility curve and downward sloping NDF curve, have been seen buying one-year synthetic forwards struck at 8.0000 with European-style reverse knock-ins on the downside around the level of 7.8500. This trade creates a dynamic zero-cost hedge that will provide the investor with either a return of around 3% if they ‘don’t’ (ie, no revaluation keeps the cross pegged at 8.2770), or the opportunity to benefit from depreciation down to 7.8500 if they ‘do’. With the one-year NDF trading at 7.9300, value in the structure is created by the short put element of the synthetic forward, which when struck at 8.0000, effectively finances the further potential for gain down to the 7.8500 level.