Dollar downed

A sharp spike in dollar/yen volatility, combined with overall greenback weakness, is causing acute problems for investors and hedgers alike. And fears about the state of the world's second-most traded currency pair are spreading. Kathleen Kearney reports

The appreciation of the yen under Yen100 against the dollar shook Asian foreign exchange markets in mid-March. Volatility in the currency pair rose to levels rarely seen in absolute terms, with any appreciation in the Japanese currency sparking a sharp rise in implied volatility.

Unlike the crises in currency markets in 1998 and 2003 when the yen spiked sharply and briefly - over a matter of just days - this latest move had been building for months. Turbulence in money markets hit highs in August, then cooled, only to flare again briefly in November and return with a vengeance when end-of-the-year balance-sheet window dressing took place in December.

As market jitters grew, the US Federal Reserve started slashing rates, most recently by 75 basis points on March 18 to 2.25%. These rate cuts, aimed at improving market liquidity and confidence in US financial institutions, caused the dollar to weaken further, sparking more rapid dollar flight and an unwinding of the so-called dollar/yen carry trade. That's because the potentially lucrative differential between yen and dollar interest rates has been eroded, narrowing from 400bp in August to 138bp based on one-year dollar Libor or to 269bp based on the 10-year swap rate at the end of March.

The yen strengthened further to a 12-year high of Yen95.76 to the dollar on March 17, following the announcement the previous weekend that JP Morgan would buy rival securities dealer Bear Stearns in a Fed-orchestrated deal for $236 million, or $2 a share.

While market sentiment has improved since, and JP Morgan has sweetened its offer to $10 a share, downward pressure on the dollar has remained substantial, analysts say. "All this change in FX volatility is due to the fact that hedge funds, retail investors and others are long carry and have been stopping out," says David Cadwallader, director for global foreign exchange at Deutsche Securities in Tokyo.

Investors taking advantage of low yen interest rates - the base rate in Japan is 0.5% - to borrow in that currency to invest in higher-yielding markets in previous bouts of high volatility tended mainly to be limited to a small number of hedge funds and banks' proprietary trading desks.

But followers of the carry trade now include funds with a wide diversity of strategies, Asian corporates and high-net-worth individuals via structured products, and the very substantial domestic Japanese retail sector. It's difficult to gain firm statistics, but analysts estimate that a few trillion yen in carry trades were unwound as a result of the yen breaching Yen100/dollar, with another similar portion of carry set to unwind should it hit Yen95.

Meanwhile, the growth in the past three to four years of online forex investment platforms has facilitated a phenomenal rise in trading activity by individuals. The principal strategy of these investors or speculators is to take advantage of short-term carry or the interest rate differential between pairs of currencies such as dollar/yen, euro/yen and current favourite, New Zealand dollar/yen. The funds converted from yen are then invested in other asset classes, often equities.

And that's causing a big increase in correlation between currencies and equities. "The dollar/yen spot is basically following the equity market quite closely at the moment," says Benjamin Anderegg, head of structured foreign exchange and commodities at UBS in Singapore. "If the equity market has had a good day, the carry trade will go up and dollar/yen will go up. If equity markets have had a bad day, dollar/yen will weaken. At the moment, I see quite a bit of correlation between these two."

This correlation between dollar/yen spot and equity is particularly close in downside moves in equities, as individuals tend to unwind their carry positions on sharp falls in the stock market, especially since they may be facing margin calls on their equity positions.

"Investors tend to be long equity and long dollar/yen because of the carry, so you have a lot of positioning," says Anderegg. "If dollar/yen comes down two, three big figures, they start looking to protect those positions; they start buying dollar/yen puts. And if the market goes up, people are happy to sell some upside, sell some calls and that will push volatility down." This is very similar to how equity markets behave, he adds.

In addition, Japan's exporters have sought to protect themselves against the collapse in margins a stronger yen brings. They are typically dollar put buyers, which pushes up volatility on the downside.

As pressure on dollar/yen spot builds, so does implied volatility, reinforcing the dollar's downside trend. "This is not a particularly new trend, but the relationship becomes clearer when the yen appreciates," says Masafumi Yamamoto, head of FX strategy for Japan at the Royal Bank of Scotland in Tokyo. "One explanation could be that when the vols are low, the yen-funded carry trades become active, and when vols rise, investors reduce risk positions and unwind yen short positions."

The rapid decline in US interest rates vis a vis stable yen rates in the past eight months has reduced the gap between the two, and this is clearly visible at the short-dated end of the market. Buyers of yen options are pushing the currency higher and driving the correlation between dollar/yen spot and implied volatility higher.

"The simple answer is the interest rate differential," says Deutsche Securities' Cadwallader. "This manifests itself in two ways. If you were to look at two 25-delta options - that is, a 25% chance of it being exercised as a dollar call compared to a dollar put - because of the interest rate differential, the strikes that you get for those are actually very, very lopsided." As the market attempts to adjust for that, it induces a very large skew in the volatility.

As the US Federal Reserve has cut interest rates four times since August, the differential between the currency pairs is now 138bp points, compared to 400bp in August. "At the moment, if you look at any sort of numerical analysis on dollar/yen volatility, what really jumps out at you is the high level of volatility skew in the two- to five-year sector, and that does to a large extent reflect market positioning," says Cadwallader.

Skew, which reflects that implied volatilities vary with strike levels, exists because of a structural imbalance in the market. Historically, investors have bought out-of-the-money puts to hedge their long positions and sold out-of-the-money calls for premium. In the dollar/yen pair, this traditionally skewed the values for dollar/yen options. Volatility for low/high strikes has increased, while volatility for high/low strikes has decreased. But instead of trading the options, the gap or skew between the options is traded, and this is referred to as a 'risk reversal'.

Risk reversals refer to the difference in pricing for puts and calls for 10-delta or 25-delta options. Supply and demand in the options market often means that these puts and calls, which theoretically should trade at the same volatility level, have differing prices. The name 'risk reversal' comes from the fact that traders actually make markets in the price difference between the 25-delta puts and calls. The effect of buying or selling the risk reversal is to change the investor's risk to being, for example, long calls/short puts or long puts/short calls.

"When a carry trade unwinds, dollar/yen puts become more expensive as traders hedge their long carry positions," says Antonio Sousa, a quantitative strategist at DailyFX.com, a US-based forex news, research and trading platform. At the same time as the carry trade is liquidated, dollar/yen risk reversals fall sharply. Towards the end of March, dollar/yen risk reversals were trading at -4.5%, meaning traders continue to pay more for hedging than for carry exposure, says Sousa.

In previous bouts of turbulence, investors would add options for protection. Now, investment managers will think in terms of second-order instruments as well - that is, risk reversals - say analysts. With further dollar weakness expected - despite some dollar firming at the end of March - risk-reversal prices are much sought after and are trading heavily in favour of yen calls.

Risk reversals show a very sharp pick-up in implied volatility for lower levels of spot, wrote Anne Sanciaume, global FX strategist at Lehman Brothers in London, in an early-February strategy report. She compared one-year volatility with 25-delta risk reversals. "Risk reversals fell very close to the lows over the period, while the one-year implied volatility is trading close to its average over the past seven years, highlighting the market's discomfort with the risk associated with the yen's appreciation," she says.

The situation was even more extreme by mid-March. "What you find is that the difference in vols between a 25-delta put and 25-delta call gives 3 or 4 vols (points of volatility), so you might pay 22 vols for the 25-delta dollar put and only 18 vols for the 25-delta dollar call," says Deutsche Securities' Cadwallader. "In the three-year (option), the differential between the two strikes is nearer to 6.5 and 7 vols. On a relative basis, that just seems nuts, because over the next three years you are less likely to see continued dollar weakness, but over the course of the next week most people will confidently say the dollar is going down. If it does, it is going to be very messy."

One reason for the sharp jump in implied volatility is the depth of the current financial crisis, which seriously undermines the rationale for systematic investment in carry trades. But since the same rise in implied volatility has not been seen in other currency pairs, there could be other significant reasons, says Sanciaume.

Indeed, the market seems to be rotating through the various currencies, as one appears more favourable or stable than another. Traditionally, New Zealand dollar/yen, for example, offered the best carry returns, but the kiwi was also viewed as highly unstable and thus often shunned as an investment tool.

Longer-term structures

In the second half of March, some parties say the chief driver of volatility was the large volume of longer-dated structures in the market that enabled clients to put on carry at very attractive levels, but which tended to leave the market-makers who sell these structures very short the downside, says one trader based in Tokyo.

"When the dollar does weaken against the yen, they (market-makers) tend to all be very short volatility, and volatility gets very good up, as we are seeing at the moment," he says. "At the moment, this long-dated structure issue is definitely the dominant force."

Power-reverse dual-currency (PRDC) notes, which offered institutional investors yield enhancement and currency protection for terms of 30 years or more, were the traditionally favoured long-dated structures of institutional investors. Target auto-redeemable notes and forwards (Tarns and Tarfs) - usually with six-month and one-year tenors - are now more in favour, say dealers. "Tarns and Tarfs offer more certainty to investors, because they include the target level, and they auto-redeem if the investor's cumulative return reaches the target level, which helps lock in profits against a possible adverse move in dollar/yen," says Lehman Brothers' Sanciaume.

Tarns and Tarfs achieve attractive strikes for going short dollar/yen by selling leverage on dollar/yen upside above the strike levels. "(They are) suitable for investors who have a bearish medium-term view (on the dollar) and are willing to assume the risk of the dollar appreciating against the yen over the life of the Tarf," she says.

A Tarf is a series of leveraged forwards with monthly expiries and an auto-redemption feature linked to the cumulative positive return received by the investor. In a single-maturity leveraged forward, the investor receives 100% of the upside of the yen, while being exposed to double the downside of the yen in return for more favourable strike rates on the contract, she says.

For years, dollar/yen spot has traded in a broad band of Yen105-125, while Japanese interest rates hovered just above zero and US rates began a slow climb from 2002 lows. The unlikelihood of a radical change in the low-yield environment in Japan encouraged both institutional and retail investors to seek yield enhancement from long-term products. And some parties say a degree of complacency set in. However, the dramatic change in the investment environment - brought about by the US subprime mortgage crisis and resulting market contagion - has resulted in a huge amount of new market positioning that is very much one-way, say FX strategists.

Previously, the asymmetry seen in the market during a major currency move was attributed to the use of hedging instruments related to the PRDC business. "Forex options exhibit a significant volatility skew induced in longer-dated options, ironically, by dealers trying to hedge their PRDC swap positions," wrote Vladimir Piterbarg in June 2006 (see Asia Risk, June 2006, 'Smiling Hybrids'). "Moreover, the structure of PRDC swaps - epitomised in the typical choice of strikes for the coupons, as well as the callability/knock-out features - makes them particularly sensitive to the forex volatility skew. This skew exposure of PRDC swaps is a problem that structurers have tackled for years."

PRDCs usually offer a high coupon initially and are callable at later stages on a rise in dollar/yen spot. While these PRDC structures have been consistently called in the past, market conditions and positioning in the past few months have meant dealers have not called the notes, meaning investors hold on to notes paying very low or zero coupons. "The main risk to investors is that dollar/yen declines in line with the forwards, in which case they receive no coupon for potentially a very long time, possibly up to 30 years," says Sanciaume at Lehman Brothers.

The hedging process for both PRDCs and Tarfs necessitates the buying of volatility as spot goes down, which has been the main reason put forward to explain the high level of correlation between changes in dollar/yen spot and implied volatility. Trading in PRDC swaps came to a near halt in Tokyo in the third week of August during the violent swings in overseas equity markets and the main reason for that was a drying-up of long-dated forex options.

Other newer products, such as snowballs, are highly leveraged structures where the strike at which dollar/yen can be bought is a ratcheting function of spot observations. These can be used to hedge Tarn, Tarf and PRDC exposure, getting longer vega as spot goes down, says Sanciaume. The snowball offers the investor a series of coupons that are linked to each other and dependent on the path of spot during the life of the product. These products, which have introduced greater amounts of leverage into the market, are one of the key reasons for the rise in implied volatility in dollar/yen spot, she adds. Buyers of snowballs have included corporates in India, Japan and South Korea.

While there are many explanations for the sharp moves in dollar/yen, it is unclear the situation is likely to improve for parties caught out by the moves in the short term.