Volatility relative value via variance swaps USDJPY negative relationship between spot and implied volatility suggests with more insistence that volatility is set to retrace lower. The relationship is concave, meaning that any spot upside should involve volatility falling faster than with a linear relationship. Nikkei vol has already gone through a conspicuous change in the spot/vol dynamics, having moved from sticky strike to sticky delta.

In such an environment, we would expect the higher spot to be accompanied by higher vol on a fixed strike basis (the entire curve is marked up as spot moves up). This paradigm is relatively more palatable for long variance swap investors compared to a sticky strike regime, in which the negative correlation between spot and vol makes a long position in variance swaps rather prohibitive.

FX/Equity spread of variance swaps, Short USDJPY 6m variance swap @12.8, 1x vega

Long Nikkei 6m variance swap @24.6, 0.34x vega Indicative bid for the spread: receive 4.3 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 profile: The further divergence between USDJPY 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 USDJPY realized volatility is above 12.8 and/or Nikkei below 24.6 in six months.