Over the past week, moves in Czech koruna derivatives markets have seemed to imply an increased expectation that the Czech National Bank's cap of 27 koruna to the euro may be set to imminently break. The cap policy has been in place since November 2013, so why the sudden lack of faith now?
There has been no major data surprise, no significant policy change and the spot EUR/CZK market is reflecting no excitement. But bets that the floor could give way through the options and forwards markets have increased to seven-year highs.
The explanation may lie in a complex derivative structure that was popular with speculators in the Swiss franc in the months and years before the Swiss National Bank abandoned its policy to put a floor under the euro's rate against the franc. The strategy is a bet that the floor holds, but just with the added proviso that if it does break, the spot rate will fall rapidly. Investors gain the most if the exchange rate stays stable just above the floor.
So how does it work? An investor first buys a digital call option in EUR/CZK with strike price at the 27.000 floor. This option pays out in full as long as spot is above the floor on the maturity date - regardless of how far above. At the same time, the investor sells EUR/CZK outright forwards to the maturity date. This position means the investor net makes money if spot collapses but is in trouble if spot really rallies. The sweet "spot" of the payoff profile is in fact EUR/CZK sitting quite happily where it is until the structure matures. Perhaps no cap-related panic here after all?