Currency futures and options make available several types of trades including calendar, or time, spreads that depend on variations in value between options on the same currency, along with near-term and deferred futures, spreads between options on different currencies with the same expiration date, covered interest arbitrage and carry trades.
“Forex five” (below) illustrates potential spreads between several currencies all having the same expiration date in June 2013. Of the five — which include the Japanese yen, Swiss franc, British pound, Australian dollar and euro — the yen is remarkable for its separation from the others in terms of implied volatility. At the point where the underlying futures price is equal to the strike, none of the other options rises above 1.5% of the strike price, while the yen achieves 2.76%.
Volatility is implied because future price variations are not known; however, the futures market forecasts are based in part on recent movements in the underlying. From Jan. 1 through Feb. 8, the yen declined 6.16%, while the other four currencies in the sample fell a maximum of 1.93%. Several had up and down changes of 2% or less. There is good reason for the market to treat the yen, at least temporarily, as a special case.
“Japanese yen” (below) shows the currency’s call options for June, September and December 2013. The heights of the options price curves are 2.76%, 3.54% and 4.21%, respectively,demonstrating a typical increasing spread between curves as the time to expiration shortens.
The widening spread as options approach expiration makes it possible to base spread trades on differences in the call price curve heights because the lower the height — except for options that are far out-of-the-money — the closer the option is to expiration and the faster the spread widens between the price curves. The varying speeds suggest selling a shorter-term call or put while buying an option that has a longer time to expiration. Because more deferred options are usually priced higher than the nearer puts or calls (options in contango), this is generally a debit trade when a single option is traded on each side.
An example based on the current yen price curves would involve buying a December call and selling the September call at the same strike price. If the curves widened in the same way shown by September to June, the price changes could be estimated for any of the strike prices shown on “Japanese yen.”
“Price curve differences: Yen” (below) shows the differences between call price curves December-September and September-June on Feb. 1, 2013. At the 1.10 strike price, the September-June difference is $1,162.50 and December-September is $975. The call premiums for December, September and June are $4,537.50, $3,600 and $2,475, while the respective futures contracts are priced at 1.0817, 1.0804 and 1.0783, representing a contango relationship. The futures price per point is $125,000.
Assuming that the call price spreads maintain the same differences, the trade begins with buying December and selling September with a net debit of $937.50, and is closed out by selling December at $3,600 and buying September at $2,475 for a net gain of $1,125. The hypothetical trading profit of $197.50, or 21%, depends on the spreads remaining constant, so the actual result could be higher or lower.
Based on “Price curve differences: Yen,” the trade should use a strike price higher than the current futures price. This is true for spreads involving calls on the same currency at different strikes, as well as spreads with different currencies at the same expiration date.
The reason for the higher strike price becomes apparent on “From June to March” (below), which shows a proposed spread between the yen and the British pound. In the same way that the higher curve was bought and the lower curve sold in the previous example, June yen calls are bought and June pound calls are sold. Recall from the “Forex five” chart that yen calls are the most volatile and highest priced while the pound has the lowest curve. We expect the pound to have the speediest descent toward zero or intrinsic value.
Data for March on “From June to March” indicate that both curves are lower and that many of the strikes now show zero or near zero prices. It also shows that the collapse in the prices of yen and pound calls have brought those that are in-the-money closer to their intrinsic values. In establishing the spread trade between the yen and pound calls, we would like to have the strike price at an area in which the lower curve is pushed over, or close-to, the zero price while the higher curve still contains positive value.
The area of strike price selection is several percentage points above the current futures price. Above a futures price/strike price ratio of approximately 0.98, the intrinsic value is supporting the pound calls without giving more benefit to yen calls. Another way to express this is that at-the-money is a dangerous area because of gamma — the speed at which put and call prices change to higher delta values. Because the March yen curve is still the highest, it is losing the gamma contest to the pound calls.
Spread evolution
Although the spread between the yen and the other four currencies is large at the moment, implying a profitable spread buying yen calls and selling one of the lower curves — a continuation of the spread differential is not guaranteed. The yen’s volatility is largely the result of Japan’s government lowering the value of the yen with respect to the dollar, as well as reducing the short-term interest rate to less than 1%. These monetary and currency-valuation policies have drawn criticism from countries connected to the euro, which does not have an equal chance at central bank intervention.
There is little doubt that the low Japanese interest rates and declining value of the yen have assisted traders who are interested in covered interest rate arbitrage or carry trades involving the yen and other currencies or securities.
Arbitrage implies that the differential between the spot prices of two currencies, expressed as an annual rate, should equal the difference between the two countries’ annual interest rates. In covered interest rate arbitrage, the currency that is undervalued is purchased with borrowed funds and then invested in securities of a second country. The principal and interest from the securities are sold one year forward and used to repay the original loan. A risk-free profit is available from the difference between the two annual rates.
Beyond transactions involving goods and services, the yen currently is valued relatively high in the futures and options markets for two reasons: 1) The currency value gains from the low interest rates resulting from central bank policy, and 2) volatility in the currency’s spot and futures prices drives up the market value of options.
Low interest rates set by the Japanese central bank may lead to carry trades — by borrowing the yen at a low rate and investing in another country’s risk-free bonds at a higher rate. For example, according to rates reported by Bloomberg on March 7, 2013, the government bond two-year yield is 0.05% in Japan and 2.88% in Australia. The two five-year yields are 0.11% and 3.10%. The rate spread is probably sufficient for profitable carry trades, assuming high leverage and after-hedging the risk of shifting exchange rates.
Paul Cretien is an investment analyst and financial case writer. His e-mail is PaulDCretien@aol.com.
