FxWirePro: Sell Short-Tenured Risk-Reversals and Bid 3m IVs To Optimize USD/JPY Debit Put Spread

USDJPY risk-reversals have been persistently bid through the back half of last year and most of this, so much so that RR/ATM ratios have now reached levels reminiscent of GFC era extremes (in favor of JPY calls, refer 1st chart) despite nominal pricing of Yen options being orders-of- magnitude more benign today. It may be tempting to associate this apparent “distortion” with the risk-bearishness – and attendant hedging demand for Yen calls – brought about by the long-simmering US/China trade conflict. The reality is far more mundane however, and rooted in the currency hedging preferences of Japanese institutions and corporates as the Fed – BoJ policy rate gap widened over the past 12-18 months. Instead of incurring the steep negative carry of selling USDJPY forwards (to the tune of 250-300bp) to cover FX risks of USD receivables /US bond exposures, Yen buying flows have increasingly taken the form purchasing USD puts/JPY calls on risk-reversals that were judged to be relatively inexpensive vis-a-vis forwards. 

Please be noted that the USDJPY positively skewed IVs of 3m tenors are signifying the hedging interests for the bearish risks. We see bids for OTM strikes up to 104.50 levels. This indicates hedgers’ interests in OTM put strikes, overall, put holders are on the upper hand (refer 2nd figure).

While negative risk reversal numbers of short tenors show some mild positive shifts and broad-based hedging sentiments for the bearish risks remain intact across all tenors (3rd nutshell). 

OTC positions of noteworthy size in the forex options market can stimulate on the underlying forex spot rate. The spot may trend around OTM put strikes as the holders of the options will aggressively hedge the underlying delta.

Hence, at spot reference of USDJPY: 107.996 levels, we advocated buying a 2M/2w 109.732/105.50 put spread when Fed and BoJ monetary policies were scheduled (vols 6.78 vs 6.45 choice), the strategy has been functioning as predicted.

Hence, currently the underlying spot is trading at 106.80 (while articulating) we wish to uphold the two-legged strategy comprised of both ITM and OTM puts, wherein short leg is likely to function even if the underlying spot FX keeps spiking, we would like to maintain the ITM long leg with the diagonal tenors on hedging grounds. The lower/shrinking implied volatility is good for options writer and increasing realized volatility is good for the bearish trend. Courtesy: JPM, Sentry & Saxo