BoJ policy shift sends traders to hedge downside yen moves

The Bank of Japan’s (BoJ) recent hawkish shift in monetary policy has resulted in a flurry of foreign exchange options trades, as the market looked for protection against downward moves in the dollar/yen spot rate.

The rate fell from 136.91 at close on December 19 to 132.331 the following day, after the announcement that the central bank would adjust its long-standing yield curve control measure – an indication that a rate rise might be on its way.

Foreign exchange options dealers say the sharp move lower drove significant demand for downside risk through USD/JPY options from both hedge funds and corporates.

“We've seen closing of previous positions, re-hedging, and new positioning, mostly focused on acquiring downside either by selling calls versus risk reversals or just buying outright downside. We have definitely seen and traded a very sharp increase in volume,” says Francesco Schiavo, global head of FX and precious metals options at Credit Suisse.

Risk reversals measure the relative appetite for puts and calls. Negative numbers indicate that puts have higher vols and are therefore more expensive than calls.

According to Bloomberg data, USD/JPY risk reversals for three-month options at the 25-delta point – the most liquid out-of-the-money options – have fallen from 0.395 on September 7 to -0.165 on December 20.

“The skew (risk reversals) moved a lot, so the price for a downside went up very significantly,” adds Schiavo.

Given the increasing cost of downside risk, the head of FX options trading at one US dealer says they are seeing demand for products with features that can make them cheaper. Vanilla put spreads have been popular, where a client buys and sells an equal amount of put options at different strike prices or expiration dates.

Schiavo also says there has been interest in digital options, which pay out a fixed amount if it expires when spot is beyond a given strike, and window options that include a temporary barrier that can knock out positions early if spot crosses them.

Despite the BoJ move, at-the-money (ATM) volatility levels moved only slightly higher from 10.88 on December 19 to 11.975 on the day of the move, according to Bloomberg data. Vol levels are generally down from the high of 14.27 when the yen touched 150 on October 20.

Signals from the BoJ over the weekend suggested it would alter monetary policy sooner rather than later, which meant the announcement did not come as a complete surprise to dealers.

Many banks had already positioned themselves for a downward move in yen, determining that its yield control policy would not be sustainable. Market-makers had also looked to balance their positions to avoid being short gamma – the sensitivity of an option’s delta to changes in volatility – over the holiday break.

The announcement caps off what has been an extremely turbulent year for FX options traders. In April, many dealers were forced to re-hedge their exotic USD/JPY positions, pushing FX vol even higher and forcing them to buy options at much higher prices. Then at the end of September, the BoJ’s intervention in its currency market led to traders turning bearish on USD/JPY vol.

Some dealers are expecting an increase in demand to sell longer-term volatility as Japan’s interest rate differential with other central bank policies begins to shrink. However, market-makers are not ruling out short-term volatility jumps.

“We’re seeing people buying gamma for January and February and then selling the longer-dated. But USD/JPY can move around between 137 and 125 within the next two months, and I think it will touch both,” says Garth Appelt, head of FX derivatives and emerging markets macro trading at Mizuho Americas.

The prospect of increased yen interest rates will also make forwards hedging programmes more expensive for corporates. After heading increasingly negative all year as US rates continued to climb, forward points for USD/JPY instruments have steadily begun to rise since November as the prospects for a Japanese rate rise became apparent.

“For people who went to re-hedge – maybe corporates where their projected cashflows are in yen over the next year – their hedging programme would need to be adjusted,” adds Credit Suisse’s Schiavo.