(Bloomberg) -- Some hedge funds are adding to wagers on yen strength in the options market on expectations that the currency will extend a rally that’s made it the world’s top performer this quarter — and saw another 1% daily gain on Friday.
They’re placing bets on the yen against currencies including the Australian dollar, Swiss franc and the offshore Chinese yuan, according to traders, who asked not to be identified commenting on the foreign-exchange market.
Signs that the Bank of Japan is intent on raising interest rates further — albeit not at next week’s meeting — have helped the yen advance about 14% versus the greenback since the end of June. The currency on Friday added to its gains, rising to as high as 140.37, the strongest since December 2023. The likelihood of rate cuts from the Federal Reserve has boosted the move, along with the rapid unwinding of short positions in the yen.
“Assuming the BOJ next week doesn’t shut the door on another rate hike around the turn of the year, we expect USD/JPY will continue to move towards 140 on a three-to-six month view,” said Jane Foley, head of foreign-exchange strategy at Rabobank in London. Other strategists see dollar-yen falling by year-end — potentially even hitting 135, a level that’s still almost 4% away.
Next week is shaping up as pivotal for these option trades, with the BOJ to deliver a policy decision on Friday, following a likely rate cut from the Fed mid-week. Recent comments from some BOJ board members signal future hikes are still in play for Japan after the policy rate was raised to 0.25% in July.
The yen is poised to get a boost if the BOJ leaves the door open to the possibility of further tightening this year, given that swaps-markets pricing is lagging behind with only a 32% probability of another hike.
Nathan Swami, head of FX trading for Asia Pacific at Citigroup Inc., said he’s seeing demand from leveraged investors for a variety options for currencies to slide versus the yen. “These plays range from vol-neutral strategies like reverse-knock-out and early-knock-out, to put or put spreads that pay market makers for vol,” he said.
Despite the currency’s advance, its daily swings may be keeping some hedge funds on the sidelines for now. The currency hit an eight-month high versus the dollar on Wednesday, but option trading volume that day on the Depository Trust & Clearing Corp. was a third below its five-day average.
“We have been surprised by the lack of what would be seen as leveraged engagement by the fast money community,” said Ruchir Sharma, global head of FX option trading at Nomura Holdings Inc., Japan’s largest broker.
The “prohibitive cost” of downside options for currencies versus the yen might be what has kept some on the sidelines until now, according to Sharma.
At the close of trading on Thursday, investors had to pay a 1.81% premium to hedge dollar-yen’s downside compared to upside over the next month. For more hedge funds to enter yen options trades, Sharma believes its realized volatility needs to decline.
This in turn should impact the yen’s implied volatility. “Recent data shows that a higher base in realized vol has kept implied vols supported,” said Citigroup’s Swami.
A lower implied volatility would be good news for hedge funds as it is one of the factors involved in market makers’ pricing formulas. A decline in it will help reduce the cost of purchasing the options, making them a more attractive bet for traders.
--With assistance from Naoto Hosoda.
(Updates with scope of yen move from first paragraph.)
©2024 Bloomberg L.P.