Forex Investment and Currency Trading

With historically high implied vol and risk reversal values remaining in the currency markets, even as realized vols have drifted lower, there is a significant opportunity to lock in attractive hedging rates for US companies with yen revenues. Currency strategists anticipate USD/JPY to hit 104 by end of year 2009 — more than 15% higher than current levels.

Market References:

• USD/JPY spot 89.75
• 1 year outright 89.10
• 1 year implied vol 16.0

Strategy #1: Vanilla Range Forward

• Buy 1 year 97.00 USD call / JPY put in $10M
• Sell 1 year 72.00 USD put / JPY call in $10M
• Premium: Zero

For zero upfront premium, companies may achieve a worst case rate of 97.00 to sell JPY. Many companies that use past quarter/year averages to set budget rates will find that this 97.00 level allows them to exceed their budget rate, while giving themselves the opportunity to participate if the JPY continues to strengthen against the USD.

Due to a downward sloping forward curve and higher volatility on the 76.50 strike than the 97.00 strike, hedgers get the benefit of protection 7.25 JPY higher than current spot, while selling off upside 17.75 JPY lower than current spot.

Strategy #2: RKI Risk Reversal

• Buy 1 year 94.00 USD call / JPY put in $10M
• Sell 1 year 85.00 USD put / JPY call RKI 69.50 in $10M
• Premium: Zero

This is a variation of Strategy #1 that uses a barrier option to achieve a better worst case hedge rate and enhance potential for upside participation. In this strategy, the hedger sells a Reverse Knock-In (RKI) USD put to fund a purchased vanilla USD call. The company gets hedge protection at no worse than 94.00, and sells off upside at 85.00 only if USD/JPY touches the 69.50 barrier over the next year.

The chart below shows that 1 month actual vols have recently diverged from 1 month implied vols, and indicate that strategies that sell implied volatility could be good risk-to-reward trades.

Implied versus Actuals - USD/JPY