FxWirePro: Achieve superfluous leverage in bullish USD/JPY scenario through option knock-ins

The promise of an inflationary US policy mix impressively propelled the USDJPY to 118.665 in the recent past. The pullback has been sharp and it is now time to take a little step back.

However, bullish USD/JPY scenario by Q1’2017 up to 125 given -

1) Strong US growth leads aggressive Fed hikes and a spike in UST yields, resulting in broad USD strength,

2) The BoJ accelerates debt monetization and Japan’s inflation expectations materially rise.

Buying regular knock-in calls despite negative skew: A negative skew impacts the valuation of an OTM call with a downside KI via the strike and the barrier. The call is discounted because high strikes are cheaper than low strikes. But such a skew can reduce the discount obtained via the barrier because it increases the KI probability.

All in all the cheaper strike effect dominates the barrier effect since the strike is located in the region where a profit can be made, while the barrier is only a condition which is met when the option is OTM. A regular KI provides a significant discount regardless of the skew direction because it strongly constrains the spot path.

Buy USDJPY 3m call spread strikes 116/119, global KI 113, indicative offer: 0.52% (vs 0.87% for the vanilla equivalent, spot ref: 113.361).

The vanilla call spread offers a maximum leverage of 2.9 times and the exotic version makes it possible to rise leverage to 4.8 times. This improvement is quite substantial if we consider that a 3m one-touch option KI 113 costs about 80%, our implied probability of activation. 

With a spot at 113 instead of 114.60, the vanilla call spread costs 0.64%, compared to 0.52% for the exotic version at 114.60. After one month, the vanilla price for a USDJPY at 113 equates the current price with a global KI. So the call spread KI is superior to the vanilla call spread provided that the barrier is hit during the first month (our scenario).

Potential risk: The maximum loss of the call spread with global KI is limited to the premium initially paid. However, it will be activated only if the USDJPY hits 113 at any time before the expiry. Otherwise, investors will obtain a zero payoff even if the spot trades above 116 at expiry.