RV FX Vol Trade Idea: Buy USDIDR 6m Vol vs Sell USDMYR 6m vol, Dislocated Structurally, Asymmetric Payoff
Examining the prevailing term structure over IDR and MYR FX vols, we can see that IDR implieds are trading at a discount relative to MYR up until 2Y. We think this is largely explained by the yield chase into EM having preference over Indonesia as of late, however this is largely something that is most likely temporary and is something that should structurally correct.
We can see from a 10y history, IDR vol has tended to trade at a premium to MYR vol for a majority of the time, and inversions of the vol spread do occur, but happen quite temporarily. As much as all EM can be basket-ed as 'one asset', we think the concept of geographical beta of the South-east Asian region should help to explain why the two vols should track one another, and thus, exhibit a mean-reverting relationship.
The aspect of a liquidity premium can also explain the thesis as to why IDR vols should trade more expensively to MYR vols. Above shows the YTD yearly bond turnover, and we can see that Indonesia is just not as liquid as Malaysia.
Looking at government bond bid/ask spreads, we can see my country provides noticeably wider spreads for foreign investors compared to Malaysia.
Foreign holdings of local-ccy govt bonds have also in recent history favoured Indonesia, which reflects the simple idea that Indonesia is more susceptible to hot-money outflows when EM does pullback.
From a cross-asset view, sovereign credit risk as well has almost always had Indonesian CDS wider than Malaysian CDS minus a few moments in crisis periods where they equalize momentarily.
Returning to the FX vols themselves, (please ignore purple line, that is just MXN current) we can see across near 5y history (captures Euro sovereign crisis, Tantrum, and the China shock in 2015), IDR is very prone to upside tail moves in vol even against other seemingly riskier FX.
If you look at the outright 6m vol for IDR, it can give you the false impression we think, that it has decent room to move even lower. A look at 6m skew, can argue for complacency with a lack of call demand, with the skew trading at its lowest post '08.
.As a final x-asset point, the ratio of the MSCI Malaysia ETF : Indonesia ETF, shows that the preference for Indonesia over Malaysia has also almost recent lows near Tantrum and euro sovereign crisis, also suggesting that if we do sell-off, Indonesia will suffer more than Malaysia does.
The vol spread as can be seen below tracks broad EM vol, and arguably, looks a little to tight relative to where EM vols are at the moment as proxied by JPM's index), and that any upside spikes in broad EM vol should see ID vols move considerably higher than Malaysia.
As a reference point for a target, a conservative target for the spread of the 6m implied vols is located at around 2.00%, whilst a suggested more aggressive normalization is at 4.00%.