Risk Latte - Dollar-Yen “Knock-out” Crisis of 1995.

Dollar-Yen “Knock-out” Crisis of 1995.

Rahul Bhattacharya
Aug 31, 2006

We have gathered through grapevine and our confidential sources in banks that there is once again a great interest in the Dollar Yen Knock-out options market. The volumes in these exotic options trade, we are told, have been building steadily for quite some time. This brings back the memories of 1995

In April-May 1995 George Soros, the famed hedge fund investor, made a lot of critical public comments about Dollar Yen knock out options. His premise at that time was that increasing volumes in USD/JPY knock outs were adding volatility to the currency markets in general and Dollar-Yen markets in particular and this volatility was largely responsible for Dollar's decline against the Yen. The theory behind this reasoning is that when certain key levels - barriers - are touched or about to be touched options with "knock out" features precipitate the execution of large stop loss orders.

A knock out feature is like a "stop-loss" order. From a trader's point of view when a knock level is about to be hit, i.e. spot trading very close to the barrier, the delta of such an option can quickly decline from say 70% to almost 0%. A trader who has pre-sold these stop loss orders via the option's knock-out feature will have to rapidly adjust his delta hedge position. If too many traders with collective volumes of billions of dollars do this then this action will very likely cause a large momentary imbalance in the market and price will move swiftly. But this is from the sell side.

What about the buy side? George Soros was primarily referring to the woes of the buy side customers then. Japanese exporters with collective volumes of tens of billions of dollars had hedged their exposure by buying USD/JPY knock out puts, i.e. the right to sell Dollar against the Yen, with knock out levels at 95. They had bet that the currency will trade far away from this barrier. But in late 1994 and early 1995 when the Dollar started falling rapidly and crossed the 100 barrier on the downside these exporters panicked and many of them started to put in new hedges and at levels of 95 (the barrier level) many of them started selling dollar outright which put enormous pressure on Dollar and it swiftly dropped below the 95 level and kept on dropping. This is what Soros was referring to.

In fact, Soros had a moot point: the breaching of the barrier level was an arbitrary event, unmotivated or influenced by any fundamental factors whatsoever; but rather, it was the consequence of the nature of the product. But such an arbitrary, mathematical event caused a shock in the FX market in general (all major currencies got impacted) and wreaked temporary havoc on many investors' balance sheets. But is argument that one should use an enforceable mechanism to restrict such activity was untenable and did not fly - for either you trade derivatives or you don't. There is no middle ground.

Reference:The above content is referenced from Derivatives Strategy, April 1995 and Eric Berger, Berger Financial Research and Bloomberg Financial Markets

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