Risk Latte - Exotic Structures Weighing on USD/YEN Options Market

Exotic Structures Weighing on USD/YEN Options Market

Team Latte
Mar 29, 2004

This is a key week for the USD. The Tankan will be out early Thursday morning, with the ECB board meeting to follow later on the day, and finally the payrolls figures on Friday. The USD might continue its correction, or reinstate its medium term trend. Interestingly the exotic structures in usd/yen are dictating the short end of the curve in the Options market.

Market Makers are long a lot of barriers between 105.00 and 104.00. These barriers are result of Asian exporters who wanted to hedge their future long usdyen positions through knockout forwards. A knockout forward structure is a combination of a yen call and a yen put having same strike and same knockout levels. The client is long one and shorts the other. Basically, (for exporters) they buy the in the money US$ put yen call with knock-out at lower levels, the levels which they think The Bank of Japan will protect and a result creates fair chance that they may not be knocked out. In such a case they can sell the USD they receive through exporting, at higher rates than the market. These Knockout forwards where done when spot was around 109.00 -ish few months ago. The strikes where they could sell the USD are between 112 to 115. Presently, those options are very close to expiry, and posing some issues for the market makers to manage. Under the current situation, the market makers are short the Reverse Knockout with a very near expiry and a very close knockout barrier. This gives the market makers lots of gamma, and also a digital risk (theoretically called pin risk) at the level of the barrier.

This profile of gamma is not a smooth bell shaped curve as we find for an at-the-money option. This gamma profile is zigzag s-shaped, with steeply positive going towards the barrier and suddenly dropping off to zero at the trigger, and negative as it goes away from the trigger, again tapering off to zero.

With lesser days to expiry, the nature of the gamma profile becomes even worse from the hedging point of view. The high gamma creates enormous time decay with spot not moving enough to make it back through gamma scalping. The markets makers will have a tendency to sell short dated options to earn back some of the time decay. If spot does not move, it might still be manageable. However if spot goes lower and triggers the barrier, the option will get knocked out and the gamma will not be there anymore. Hence, the market makers will be trapped with a short gamma position emanating from the short dated options they had sold earlier to hedge. Also, is spot goes higher back above 106.00, again the market maker will be short gamma coming both from the short dated option they had sold and also the short reverse knockout with the client. This presents a very interesting challenge for the market marker, which I am facing too.

With these exotic structures weighing on the market, we can expect the front end volatility to shoot once the spot breaks 105.00 and goes lower, while if spot stays here, the volatility will get softer from the pressure of the better offers from market makers to earn decay. However, if spot creeps up again slowly, the volatility might not get as bid as expected when spot breaks 105.00, as the risk reversals are so much skewed to the downside. Having said that I would like to point out that, if there is broad-based buying of USD by Central Bankers, and spot spikes up very fast, then good chance we see the bids getting better on the short dates.

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