Taleb-Style Trade Idea: Long CNY

Wednesday, May 12, 2010

While I'm certainly not the originator of this trade idea, I find it very interesting for a longer-term play. It is a trade with low downside risk and out-sized upside gain potential. The idea is long the Chinese Yuan through the Van Eck Market Vectors-Chinese Renminbi/USD ETN (NYSE:CNY). The primary risk in this trade is the opportunity cost of capital should revaluation not occur in the near future. Yet, exposure to the possible right tail payoff could be well worth it.

China is currently struggling to fight inflationary pressures much of which are driven by an artificially low managed floating exchange rate against other currencies. For decades the renminbi was pegged to the dollar at various rates used to achieve economic goals. From 1997 to 2005, the renminbi was pegged at $1:¥8.27. The $:¥ is currently at ¥6.8272 and is managed by the People's Bank of China (PBOC) to remain within a 0.5% band around parity against a basket of currencies as determined by the PBOC. The International Monetary Fund estimated purchasing power parity (PPP) in 2008 was ¥3.798 whereas the renminbi averaged a value of ¥6.9451 throughout that year. This implies that 2008 rates were a 45% discount to PPP. The shift from a peg to a managed floating rate has gradually allowed the yuan to appreciate up to current levels but a significant under-valuation remains.

Pressure on China's central bank to revalue the remnimbi continues to build from both internal and external forces. China is well aware that in order to become a leading global economic power it will need to transition to a floating rate regime. Externally, the US has threatened to label China a currency manipulator while European counties have likewise voiced their complaints. April 30th readings on inflation showed consumer prices increasing 2.8%, producer prices jumping 6.8% and property prices rising a staggering 12.8% year-over-year. Retail sales rose 18.5% for the month. These data points show that even with the debt woes in Europe, the PBOC may have to further tighten monetary policy. Part of the policy could very well include a re-valuation of the yuan.

This trade idea is modeled after the Nassim Nicholas Taleb concept where rather than striving for the consistent, high probability gains while exposing yourself to the black swan left tail event, look for circumstances that offer a skewed risk/reward structure where the mean return is relatively low, there is virtually no left tail risk yet there is exposure to a large right tail profit potential.

Disclosure: No position currently.
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