A yen for understanding

Let’s see if I can make sense of Jansen’s penultimate post today.

Exotic option hedging contributed to the flattening of the Treasury curve today.

Recall that a “flattening” yield curve means that the spread between yields on shorter maturities and longer maturities declines. Like in this picture from Bloomberg (orange = yesterday, green = today):


That may not look like much, but note the delta bars at the bottom of the picture; they tell the story.

Here is an excerpt of an explanation of the option structure and what forced the hedging:

– Power Reverse Dual Currency notes.. Yield enhanced notes issued in Japan.

– They pay a coupon in USD linked to the USD/JPY exchange rate, floored at zero.

(Aside: If you were to do a search for “Power Reverse Dual Currency Notes”, how many hits would you expect?)

OK, so these instruments give you periodic payments in dollars that are inversely correlated with the Yen. I am not sure what “floored at zero” means in this context, exactly, since USD/JPY cannot go to zero nor to infinity. Probably.

– The coupon rises when the yen weakens, and falls when the Yen strengthens.

– They have long maturities of 30yrs or more, and are callable.

“Callable” means that whoever sold you these things can buy them back from you whenever they want. If the Yen were to become very weak, so that the coupon payments became very large, the seller would be more inclined to exercise this option.

And vice-versa should the Yen strengthen.

– as the yen strengthens (as is occuring) the coupon of the bond falls and the likelihood of it being called declines. Which lengthens the duration of the bond and forces dealers to receive longer maturity swaps to hedge their longer FX forward exposure

(Definition: FX = “forex” = “foreign exchange” = currency trading)

Recall that the duration of a bond is how sensitive it is to interest rates, which can be calculated as a sort of weighted average of when you will get your coupon payments. If the instrument should be called, then the payments in the distant future will never happen. More to the point, the more likely the instrument is to be called, the more likely it is that the distant future payments will never happen. Thus the duration of this instrument depends on how likely it is to get called.

So the causal chain is: Yen strengthens ⇒ coupon payments fall ⇒ issuer less likely to call ⇒ duration increases.

Apparently, these gadgets are largely sold to retail clients who do not bother to hedge their portfolios. (Like you and me, they are the suckers at the table.) But the dealers who sell them need to hedge very badly. Since they sold something whose duration is increasing, the total duration of their portfolio is declining, and they need to add something of positive duration to balance it out, like a long-duration bond or the receiving side of a swap.

Incidentally, a Reuters article last November blamed these things for the negative 30-year swap spread, at least in part.

– estimates vary as to the sizes involved, but an estimate from Credit Suisse last year was that for every 1% move in USD/JPY required the dealers to adjust their USD rates position to the tune of $3bln 10yr notes equivalent

– a more recent estimate is that for every 1% fall in USD/JPY requires hedge adjustments of $1bln 10yr note equiv

– the new Japanese govt is not inclined to intervene in the FX mkt (unlike its predecessor) and perception is that $/¥ may gravitate towards 75, with the next key trigger level being 90

Well, we are through 90 today.

Jansen’s closing post also bears reading.

In a previous post I noted that exotic option hedging had contributed to the demand for the long end of the Treasury market. One interesting aspect of that article is that the author noted the animus with which the new Japanese administration views currency market intervention. The author thought that the yen could drift towards the 75 level.

I would differ and suggest that it would not drift there. If it continues to slide it will be more of a cascade as opposed to a drift

Remember that scene in Aliens where the guy holding the motion sensor yells out, “I got movement!” ?

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