FX options pricing is showing a market that is growing wary that the Bank of Japan will tweak policy on Friday. Higher option prices shows the market is paying up for options that would hedge that risk.
Implied volatility for JPY-related options expiring after the BoJ decision eased marginally after last week's dovish comments from the BoJ governor. But, they bounced back this week and spurred further after an FT article (link here, FT is gated) cited warnings from several big banks about the increased risk of BoJ action.
Shorter-dated expiry FX option implied volatility (IV) is back around recent and longer-term highs. Most noticeable is the implied volatility premium for JPY calls over puts - options that give holders the right to buy JPY versus sell it. One-week expiry risk reversal contracts show that this USD/JPY downside versus upside strike volatility risk premium has exceeded levels of before the March 10 BoJ decision to stand at new 3-year highs around 4.3.
This chart is via Reuters - be sure to read the annotations, those noting the jumps in Implied Volatility (IV) ahead of BOJ meetings and also the explanation of why I am saying IV is surging while what you see is a plunging line!
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If you are a trader of options you will be very familiar with implied volatility. Or even just a well-informed trader of other derivatives or the underlying.
If not though, here is an in-a-nutshell description of IV:
- Implied volatility is a metric that captures the market's expectation of the future volatility of a financial instrument, in the case of what we are discussing here, USD/JPY.
- It's a key concept in options pricing and is derived from the price of an option. The term "implied" is used because the volatility is not directly observed, but is instead backed out from the price of the option.
In simple terms, implied volatility is an estimate of how much the market believes the price of a certain security (USD/JPY here) can move over the lifespan of an option contract.
- A higher implied volatility typically means that the market expects a larger price swing, and vice versa.
- High implied volatility means the price could move a lot, but it could be either up or down.
- Implied volatility changes as market sentiment changes and is influenced by factors like upcoming events that are expected to impact the stock price (like earnings announcements, or in our example here the Bank of Japan meeting impacting on the yen), the supply and demand for the options themselves, and changes in the overall market climate.
- Note that implied volatility is different from historical volatility. While the latter measures how much the price of a security has moved in the past over a given period, implied volatility is forward-looking, representing expectations about future price movements.
