Tuesday, February 5, 2013

Do 1yr variance-swaps shorts on USDJPY make sense @12.80% bid?

I think so.

I'll introduce 3 charts here.

1/ 30-day realized volatility on USDJPY fx-cross.
2/ A Histogram of 30d volatility since 1995 (including all the crisis)
3/ A chart on USDJPY 1y ATM volatility (it's the 3-day moving average, except for the last 10 data points)

Basically realized volatility has been in the 82nd percentile of historical observations in USDJPY 30-day since 1995.

Looking at the charts the take-ways are basically that it'd be tough days for volatility (or variance) sellers earlier in the Asian Crisis, then on the Russian Crisis and then a more normal sailing all the way up to the 2008 financial crisis when very high daily volatility was actually the norm for a few months.

I just checked and the BID is 12.80% for a short-vega position on 1year USDJPY variance swap, but I am suggesting readers should perhaps think about this trade and how it would behave within your portfolio.

The Japanese government and the Bank of Japan have been explicit that they want to kill deflation, and target mild inflation of around 2.0% in the country. Fine.

But in the mean time there are a few aspects we should keep in mind:
- Parabolic moves usually end in tears
- Policy Makers do not need that
- Japan's trade balance is in deficit, largely due to higher energy imports which have been more expensive due to JPY's devaluation
- Who is getting hurt by short-vega and short-gamma positions right now? Likely a/ banks [market makers in FX space] and b/ corporates [exporters] that are hedged, but need to place capital to cover mark-to-market / margin calls. Corporates, especially, could see a funding squeeze
- A lot of key levels have been broken like butter, implying short squeezes in price
- Implied volatility has skyrocketed also fast: people had to buy vega back to either reduce exposure or to realize a loss.
- Policy Makers have been vocal about the USDJPY level of 95.0. We're "there" already considering it was high-70s just a few months ago.
- Fears of destabilization in the JGB market should make policy makers worried about a sell-off in JGBs.

Where could this go wrong?
- More and more knock-outs / barriers all the way above current USDJPY levels or in other JPY crosses
- The situation really getting out of hand and policy makers losing control of things, meaning capital outflow of the country, possibly with very negative consequences for their bond market.

So... Food for thoughts.

PS: to spice things up perhaps it'd be good to use the possible carry of the trade to buy JPY Swaption payers.

Backtesting this strategy SINCE 1990 (shorting 1y USDJPY variance swaps) I got that the break-even level for expected return was, on WORST CASE situation, 11.49% for a positiong carried for the entire maturity of the swap.
So that is the Worst PnL x the Best. Since negative PnLs occurred less frequently, I think odds of this happening are smaller than thought.

Here are the summary of the backtests for 11.49% (break-even), 12% (level of ATMF 1y implied vol now) and 13% (current level in realized volatility).

*Disclaimer: charts and data are presented as I receive/see them. Sources are usually not checked for validation and my own calculations are of 'back of the envelope'-type. I am aware that some math that I do myself might be wrong and/or misleading to some extent. In financial markets the rate of change of economic data is often more important than the actual level and the perception of 'what is priced in' is more important than 'what is actually going to happen'. This is actually the way people pick entry and exit points. So... yes, sometimes you might say 'This guy is an idiot, this is way wrong!' with a high conviction, being right. Not to worry. Markets are made of expectations and the clash of conviction between its participants. Portfolio managers know that being an idiot is sometimes profitable and being smart is often a bad choice. It is all reality, sometimes good, sometimes bad. By the way: corrections to my analysis and intelligent debate is welcome. theintriguedtrader AT gmail do com


  1. Hi, Thanks for interesting post. Are there any exchange traded variance swaps available, or should one go for OTC-market? VIX and Vstoxx are at pretty depressing levels to short anymore....

  2. Don't know about Exchanged Traded Variance Swaps.. Only seen them on OTC. Any major house trades them: GS, Nomura, Barclays, DB.

    It is very different to trade VIX or stoxx futures than doing Variance swaps.