May 7 (Bloomberg) -- Investors should use options to capture Mexican peso gains against the dollar amid expectations for fiscal reforms, according to Lehman Brothers Holdings Inc.

Mexico's central bank unexpectedly lifted the overnight benchmark rate to 7.25 percent on April 27, surprising all 16 economists surveyed by Bloomberg, who predicted the rate would be left at 7 percent. The peso has appreciated about 0.6 percent since the rate increase, trading at 10.8958 per dollar on May 4.

``The increase in local rates, since the central bank's surprise rate hike, has helped support the peso,'' said Gordian Kemen, emerging-markets strategist for Latin America at Lehman Brothers in New York. The options trade we recommend ``is a good way to play any further upside potential for the peso.''

Kemen recommends that investors purchase a so-called call spread on the Mexican peso, which will produce profits if the currency strengthens. Call options grant the right, but not the obligation, to buy the currency at a pre-set price.

The central bank rate increase was the first in almost two years. Policy makers said they raised rates to head off the threat of inflation. Inflation in Mexico has stayed above its target range of 2 percent to 4 percent in six of the past seven months as food prices surged this year.

``Fundamental Improvement''

Mexican Finance Minister Agustin Carstens detailed the need for fiscal reform, which included reducing dependency on oil export revenue and improving tax collection methods on April 18 during a press conference.

The fiscal reform package ``would be a fundamental improvement for the country,'' said Kemen. ``The market has been largely ignoring it up until now.''

The options trade Kemen recommends will expire on July 25, fitting with his view that the peso will begin to weaken later in the year. Lehman Brothers predicts the peso will drop to 11.20 per dollar by year-end as growth slows in the U.S. and Mexico.

``Weaker U.S. growth continues to be the largest risk to the peso,'' said Kemen. ``The U.S. and Mexico are symbiotic twins in that context.''

Job growth in the U.S. fell to its lowest level in more than two years in April as payroll losses spread from struggling homebuilders and factories to retailers, the Labor Department reported on May 4. The U.S. buys about 80 percent of Mexico's exports.

The Call Spread

This call spread is a two-legged trade that involves the purchase of a peso call option at a so-called strike price of 10.85 and the sale of another call at a strike price of 10.70. Kemen recommended the trade on April 26.

The sale of the lower struck option helps reduce the cost of the trade and gives it a pre-set profit potential.

With this options trade ``you have a defined profit range and a well-defined loss, which currently makes it more attractive than'' buying the actual currency, said Kemen.

The maximum loss on the trade is the price an investor paid for it. Maximum profits, which would be about three times potential losses, would occur if the dollar-peso exchange rate was at 10.70 at the July 25 option expiration.

A tumble in volatility on peso options, to the lowest level in almost two years, has made prices cheaper and options a more attractive way to capture gains if the peso appreciates, said Kemen of Lehman, the fourth largest U.S. securities firm.

Implied volatility on the one-month options on the peso against the dollar fell to as low as 5.6 percent on May 4, the lowest rates since June 2005. Implied volatility is down 2.65 percentage points from the year's high of 8.25 percent, and has tumbled 9.15 percentage points from 14.75 percent in June last year. The 14.75 percent level, touched once also in Sept. 2002, is the peak in one-month volatility back through June 2000.

``Volatility has come down very drastically,'' said Kemen. ``This has made options cheaper.''

Traders quote implied volatility, a measure of expected price swings, as part of setting options prices. Options are contracts granting the right to buy or sell a specific amount of a security in a given time span.

To contact the reporter on this story: Liz McCormick in New York at Emccormick7@bloomberg.net.

Last Updated: May 6, 2007 19:54 EDT