Is the Risk of the US Election Already Overpriced? BOA Asks

US election risk premiums are becoming heavily priced in the foreign exchange markets, according to Bank of America Securities, which suggests that these premiums may already be inflated.

Historically, most foreign exchange volatility does not rise sufficiently to justify the implied volatility premium surrounding the US elections, the analysts stated in a note dated October 7. They anticipate that constrained volatility could serve as a catalyst for the FX carry factor to perform favorably after the election.

The bank observed that there is a significant risk premium in the foreign exchange markets in advance of the US election, particularly affecting Asian emerging markets. They found that the median major FX pair has incorporated a 108% premium compared to the averages seen in 2016 and 2020, as indicated by daily fluctuations in the two-month implied volatility two months before the election.

However, the bank noted that emerging market volatility in Asia has not reflected the US elections since 2012, leading them to favor a reduction in implied volatility.

In a stable election scenario, they expect the USD/CNH exchange rate to remain within a range of 6.85 to 7.30, with options at similar levels offering appealing premiums to those selling volatility.

Consequently, they believe that taking a short position on a USD/CNH strangle is a sensible approach to capitalize on rich volatility premiums. The potential risk to this strategy would arise from larger-than-expected fiscal stimulus in China, which could lead to significant movements in the USD/CNH rate.

At 04:35 ET (08:35 GMT), the USD/CNH was trading 0.5% lower at 7.0621.