Gadzooks! Which is the safest of them all? Clearly Swiss Francs…

This is one of those moments most currency traders and macro hedge funds feel REALLY sheepish/scared:

That'll hurt.  Source: thinkorswim by TDAmeritrade.

That’ll hurt: Swiss Franc futures reverse mightily. Source: thinkorswim by TDAmeritrade.

Imagine the situation:

  1. Beginning: the Swiss Franc seems a safe play.  Very carefully managed by the Swiss National Bank (SNB), which REALLY doesn’t want much variation in their safe-haven currency, you assume a stable relationship.
  2. The initial trade: Swiss interest rates are very low – in fact, negative.  This sets up the proverbial carry trade – borrow in Swiss francs to fund a bet in any currency.  Let’s just use the USD, as it has a terrible low interest rate too, but is still pretty safe.  So you pick up 50bps (around 0.25% in the US, set against -0.25% in Switzerland) in a pretty safe pair.
  3. Life is good: this interest rate differential is picked up in the futures through the near-continuous downward trend we see in the chart above.  Ahh, relax and go short this futures contract.
  4. Today: Oh Shit.  The SNB decides enough is enough, and stops putting a floor on its safe-haven currency.  Interest rates move to -0.75%, so your carry signal says stay short the contract.  But the underlying moves about 30% against you, negating about 60 years worth of the old carry returns.  Oh dear.  Hopefully you didn’t cash out at the worst point, as the pair has only moved about 15% at this point.
  5. Statistics?!? Who cares?  The implied volatility of the future has been around 10% p.a., or around 0.7% daily.  So a 30% daily move is about…45 standard deviations.  We’re talking infinitesimal probabilities.
  6. When writing uncovered calls really sucks.  God forbid you had a system of writing calls to collect the carry here.  Suppose you wrote a $1 call on the contract above yesterday, giving yourself a bit of room on yesterday’s $0.987 close to collect the carry.  Your premium? About $.005 for a 30-day option, which is now MTM at about $0.124 (essentially delta=1 here, so whatever the difference between $1 and the current market price).  Your loss is about $0.12 per contract, or $15,000.  So you collected $625 in premium to now need to post $15,000.  Ouch.

In sum: I’m sure we will find out about certain funds which collapse from this type of trade, or those who trade against consensus and made a ton.  I am very happy not to have been playing this currency.  For option traders – this is the reason you use defined risk trades: yes, you give up a fraction on every trade you do, but it can save your bacon when things like this happen.

Wow.

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2 thoughts on “Gadzooks! Which is the safest of them all? Clearly Swiss Francs…

  1. All very true. I remember speaking at an internal meeting of AHL a couple of years ago, saying that I didn’t see the point in trading a market where the government set the price. I see EMG is down a little today so I don’t know if people are just concerned about hedge fund exposure generally. I wouldn’t imagine that the position would be especially large.

    You’re right that the only way safe way to handle these is to be long options. If you think CHF will depreciate against EUR then buy a call on that. Your downside is limited to the premium. That’s the smart global macro way. On these very non linear, almost binary, positions there is no point trying to use stop losses, you just blow through them.

    I never traded CHFEUR but I stopped trading CHFUSD IMM myself late last year. I decided with CHFEUR pegged it was just a proxy for EURUSD, and still exposed to the blow up risk of this happening. Each CHFUSD IMM contract would have lost about $16K. I’ve still had a relatively large loss in SMI equity index futures, which have moved about 10 times more than a normal daily move today, though manageable.

    As well as the risk of HF blowup anecodotally, quite a few people in the retail space were in this trade. Watching Bloomberg TV over lunch I wondered how many of the retail FX providers that were advertising will still be in business tomorrow. Although I don’t think the world will miss the insane leverage the cowboys in that industry provide, I feel sorry for the people who have been meddling in something they never really appreciated the risks of.

    Liked by 1 person

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