Making the most of fresh yen strength

BACKROUND: Over the past two years there has been a demonstrably close relationship between the movements of Asian currencies against the US dollar and inflows into their equity markets. For example, since February 2003 there has been an 85.8% correlation between the inflows into Japanese equities and the performance of the yen against the dollar. As such it is important to note that there has been a marked pick-up in the pace of inflows into Japan’s equity markets since September last year.

PROBLEM: According to the Japanese Ministry of Finance’s own data, foreign investors net purchased ¥4.1 trillion of stocks between the start of September and the end of January. This took their overall purchases since April 2003 to a substantial ¥20.578 trillion (around $195 billion) and their overall ownership of Japanese stocks reportedly to the equivalent of around 22% of the overall value of the market. Given this sharp pick-up in interest in Japanese equities in recent months, how can investors position themselves to take advantage of renewed yen strength without exposing themselves to short-term volatility?

Looking at one-year at-the-money implied volatility prices over the decade and comparing them with how volatile the market subsequently proved to be -- one-year historical volatility measured on a high/low/ open/close basis -- it is clear that expectations have rarely been matched by what actually happened. For example, it is very noticeable that one-year prices consistently failed to predict how volatile the market would prove to be in the period from June 1997 until March 1999.

Equally, as a direct result of the events of October 1998, they failed to capture the decline in market volatility that occurred through until September 2001. Between then and March 2003, prices did prove a reasonably accurate predictor of what would subsequently happen. However, since then it appears that one-year prices have consistently under- estimated how active the market would be. Although the gap over the past 21 months has been nowhere near as great as during the 97--99 period, there has nevertheless been a consistent gap. To illustrate this it is simply worth noting that the one-year ATM price 12 months ago stood at 8.75%, whereas the actual volatility of the price of USD/JPY over the past 12 months was 12.17%.

Solution: The following simple strategy would be of interest to those managers who believe both that the yen will trend stronger and that the market will be more volatile than is currently being priced in.

Tenor: 1 year

Buy 97.50 USD put/JPY call, K/I 107.50

Sell 110.25 USD call/JPY put

Net zero-cost

Spot reference: 105.00

This strategy allows the buyer to benefit from an eventual yen appreciation, following a period of greater volatility in price action. At expiry, the buyer of the 97.50 yen call will only be able to exercise the option if, at some point during the previous year, spot has traded at 107.50. If spot hasn’t traded at 107.50, the option is deemed non-existent, thus giving no possibility of exercise. As long as spot is below 110.25, the yen put will expire worthless -- if it is exercis ed, the seller will be short USD at 110.25.