Hedge Funds Shorting USD/YEN and Buying USD Calls: A Case of Skew Inversion:
Jan 25, 2004
The record current account deficit in US might not be sustainable. It can only be financed through Foreign Direct Investments. For FDIs to flow into US, the US assets needs to be more attractive to foreign investors, which means that the value of US Dollar has to go lower. Over the last year we had seen USD loose more than 10 pct of its value with respect to Japanese Yen and more than 20 pct with respect to Euro. This calls for a weaker USD, with respect to Japanese Yen, which was the crux of the last G7 meeting. However The Bank of Japan had spend more than 55 billion USD from the beginning of this year, trying to stem the rise of Yen (through intervention), but still USD/YEN is hovering around the lows of the last few years. After the last G7 meeting in September 2003 we saw USD/JPY break the much dreaded support at 115.00. The next G7 meeting is coming up on the 6/7th of February, and whole market reckons that they will reiterate the same theme; implying USD/JPY might break 105.00 easily. The Big Hedge funds are putting short USD/YEN positions to exploit this. The Bank of Japan however have been firm on its stance of defending USD/YEN from going lower.
Few interesting observations on the market under these conditions: Hedge funds had been shorting USD/YEN and to protect their upside risk, were buying low delta USD calls for post G7 dates. They reason USD/YEN will break 105.00 and will gap down further to 103.00 where they can take profit, and hopefully the Bank of Japan might be there as well trying to defend like before. In case, it does not and if the G7 members are not that keen on the re-alignment of global currencies through the weakening of the USD, then USD may bounce back sharply; in which case those low delta USD calls will automatically act as stop loss. These are cheap insurance against the massive amounts of short USD/YEN positions they are taking. Moreover as the hedge had paid in the market, the whole market is short those options. Hence the low delta USD calls are very highly bid in the options market.
Usually the skew of the market favoring the movement of the currency pair lower or higher are reflected through the risk reversals. When USD/YEN crashed through 115.00 last September the risk reversals were all sharply skewed in favor of Yen calls/USD puts. From 1 week till 5 year maturity, the whole curve was favoring the Yen calls/USD puts with the 1 week 2.5 vols over and the 1 yr 3.0 vols over for the Yen call/USD puts (that's 25 delta risk-reversals) , reflecting the markets view of USD/YEN going much lower in the future. Interestingly, today morning because of the demand of low delta USD calls, in relation to the G7 dates and before, the risk reversals for the 1 week till two weeks are favoring Yen puts/USD calls (by around 0.3 vols higher for Yen puts/USD calls), while post G7 dates are favoring Yen calls/ USD puts, ( 0.8 vols favor the Yen call/USD put from 1m to 2.6 vols favor the Yen call/USD put the 1 yr.) This is a very interesting phenomena on the volatility surface of USD/YEN, the surface skew completely flips over from one side to another and the inflection curve is the G7 WEEKEND. The phenomena can only happen under such situation and market positioning.
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