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The BoJ maintains status quo in its monetary policy, focusing to soothing 10Y Treasury bond yield, the benchmark for long-term borrowing costs, at around zero pct and keep the overnight interest rate around -0.1%. and asset purchases program at ¥80 trillion.
As a result, the Yen volatility tends to behave as a global risk complex across asset classes rather than domestic factors, reflecting the core market pulse. Interesting idiosyncrasies can, however, perform between assets and stretch trading opportunities of particular interest when the underlying assets are fundamentally related.
One of the key market themes was that the BoJ’s peg of long-term yields will transfer the suppressed rate volatility to the currency and equities. USD/JPY volatility already has benefited from the volatility boost, while Nikkei volatility remains on its lows (Graph 1). We find value in hedging a short USD/JPY volatility trade in going long Nikkei volatility.
The strategy: FX/Equity spread of variance swaps
The execution: Short USDJPY 6m variance swap @12.5, 1x vega long Nikkei 6m variance swap @24.6, 0.34x vega, indicative bid for the spread: receive 4.1 vols.
Once vega neutral and beta-adjusted, the spread is currently 1.8 volatility points (Z-score of 1.2 standard deviations) above its long-term average. Target a tightening of 2 vols.
Risk profiling: The further divergence between USD/JPY and Nikkei volatility A spread of variance swaps is exposed to the volatility differential between two assets. Investors holding the position until the 6m expiry face unlimited losses if the USD/JPY realized volatility is above 12.8 and/or Nikkei below 24.6 in six months.
