Dollar/Yen Moves Lead To Windfall Profits/Losses In Currency Options

LONDON--The violent move in dollar/Japanese yen over October 7-8, has created "massive windfall profits and losses" among currency options players, say industry sources.

The yen's unprecedented rise meant that out-the-money options positions that were relatively insignificant before the move, were suddenly in play.

"Because the move was unforeseen--not to mention its sheer magnitude--banks that bought short-term protection against a downward blip in the dollar, but were long-term dollar bulls, were hit by a move they never foresaw in their wildest dreams," says a currency options manager at a major brokerage in London.

During that week, yen volatilities were at the highest levels ever traded among the G7 currencies--high even by emerging markets' standards.

In the spot market, dollar/yen moved from about 134.20 as the high for the week, down to a low of about 111.55.

Meanwhile, yen volatility for the one-month period was trading at nearly double its historic high (of about 22 per cent), at 42 per cent. According to one options analyst in London, overnight volatility was trading at a 125 per cent high and one-week vols were up to 65 per cent.

"Forty-two per cent one-month yen and 24 per cent six months is something that the market never saw before," says the options broker. "So banks that were running risk reports allowing for 'normal' spot moves, ended up with positions they never anticipated."

As dollar/yen moved from 134.20 to 111.55, strikes that banks never thought would come into play suddenly became exercisable.

For example, if two weeks ago, a bank sold an option to a customer expiring in three months' time at a strike of 115.00, with a call on the yen for $500 million, the impact would have been negligible, creating a synthetic long position in spot terms of about $20 million.

However, when the market fell to 115.00, the position balloons to a synthetic long position of $285 million. And when the market moved to its low around 111.55, this position is equivalent to being long $330 million.

"With the spot market being very illiquid, the hedging of this exposure created a massive problem for options traders," says the broker. "So an option that was relatively insignificant, showing a small plus or minus on banks' risk reports, suddenly meant windfall profits or losses."

Compounding the problem is that liquidity dries up at these levels as market players are sidelined, which exaggerates the swings.

Some sources say that a few of the major currency options players (primarily US and European banks) lost anywhere from tens of millions of dollars to hundreds of millions.

While the largest players may be able to absorb such hits, some of the smaller banks will have to question the level of their future involvement in the product, sources say.

"I think we'll see players take a cautious step back," says one global forex manager at a major international bank.

However, as another source notes: "Where there's losers, you can be sure there's going to be winners as well."