Trading a planned drop of FX peg

Question

I've been playing around with ideas (not primarily to make money) about what exactly is going to happen when Czech National Bank will leave the EUR\CZK peg? It's been on for roughly 2.5 yrs as a contra-deflationary measure by depreciating the currency (from 25.5 CZK to 27 CZK for EUR). FT write about the current situation in a nutshell

Surely all participants have been calculating for months how to trade once the intervention stops. Pretty sure everyone will be speculating on appreciation (roughly levels suggested by Big Mac index or something like that - ideas for indicators?).

But CNB says(slide 29) it wont happen since the price level rose accordingly. Yet from market graph there is clear downwards pressure on the rate - so if the market thinks its gonna go down, would it?

Here is 4 hour graph with pressure on the limit (EUR\CZK se we expect it to go down (CZK appreciating)):

Or what about going long on put options? But then getting European option, I assume the market would be volatile so cant get the exercise date correctly.

So basically I'm after if there is a historical parallel to this? CHF in Dec 2015 was totally unexpected so there was massive fuzz and I dont think anyone has CZK mortgages etc.

Do you reckon the market would move big time or not? CNB has history and reputation for being quite straightforward, but surely they wouldn't put in presentation that upheaval is expected as it would definitely result in one.

Answer 1

The lesson learned from the CHF episode is that the central bank eventually gets nervous about the losses they are likely to incur. Theoretically any central bank can print its own currency and sell it into the open market without limit, but if the currency eventually appreciates, there will be a massive loss. The capitulation generally occurs when the currency is trading at the peg in large volumes. In your example, it is trading at the peg in small volumes, suggesting a more modest appreciation than the CHF if the peg breaks.

The fx option market might be able to tell you something about the expected timing of any peg removal. If one month options are very high vol versus one year options , it could be sooner rather than later. European options are ok for speculation on this, since you can delta hedge in the fx market if the peg disappears during the term of the option.

Answer 2

The other thing about the CHF peg was the central bank gave no indication and if I remember rightly in the previous meeting said they'd continue with the peg. Then one day, without notice, there's no central bank bid (of 1,000,000,000) on EBS. (Most bids on EBS are only 1,000,000 so that's an unusual size)

Whereas here the CZK central bank is giving notice to expect no bid on EURCZK in mid 2017. So I'd guess there's more chance of a contrarian reaction, but I'd guess a long put is likely to come good in the following weeks.