Description

We’re constantly looking for inexpensive insurance policies on macro events. Recently we’ve found an opportunity to purchase puts on the Japanese yen very interesting. One can purchase sizable put contracts at limited costs that could potentially result in a large payoff.

Problems in Japan have been well-documented in the press so I will not review them in here, but I’ll point you to our write-up from 2011, which gives an overview of the economic situation in Japan that largely persists today – problems around debt to GDP, aging population, slow growth, export-oriented economy reliant on cheap yen, etc. Nonetheless, I’ll provide a brief background on recent economic policy steps and outcomes.

Since Dec 2012, when the current Prime Minister, Shinzo Abe, was re-elected, Japan implemented a new economic strategy, referred to as “Abenomics”. Abenomics revolved around “three arrows”: monetary policy, fiscal expansion and structural reform. But really only one arrow, monetary policy, was fired aimed at achieving 2% inflation target. Despite trillions of yen (tens of billions of dollars) in economic stimulus and monetary easing by Bank of Japan (BOJ), consumer prices haven’t noticeably increased. In fact, the BOJ has postponed its timeline for hitting target inflation twice since 2013, so needless to say Abenomics hasn’t delivered on its primary goal (inflation).

In the meantime, economists question how sustainable Japanese monetary policy is – they’re purchasing 80 trillion yen (~$780B) of bonds annually. Further bond purchases are going to be more difficult to execute as a result of collapse in JGB trading volumes. This reflects the fact that major Japanese banks have already sold down more than half of their existing JGB portfolio. In aggregate, Japanese banks holdings of JGB have declined >50% since bond buying program was initiated in April 2013. The remaining JGB bonds at Japanese banks are long dated and positive yielding, which they might be reluctant to sell. Apart from bond buying, the entire stimulus packages are getting larger and larger – the most recent pending package will be the largest package relative to (as % of) GDP since 1990. The concern is that BOJ can’t stretch itself much more.

Since the current monetary policy hasn’t worked, many believe that Japan is running out of “ammunition.” Abe recently rejected that view saying he expects “bold monetary easing measures” when the central bank’s policy board meets in September. In the meantime, the press has reported that Abe met with Ben Bernanke who’s a proponent of the “Helicopter money” theory. Helicopter money is an increasingly popular idea that has been discussed at length in press. Simply, it is a policy where the central bank bypasses the financial system as an intermediary, thus opening a new channel directly to the wider economy. The goal of the policy is to trigger inflation by printing new money and putting it in the hands of companies / individuals, which, in theory, should encourage spending rather than saving. In reality, I don’t think anyone knows what the outcome would be.

Inflation aside, a weaker yen has been another focus of the central bank and government to try to revive the Japanese economy. Unlike in the case of inflation, monetary policy did result in favorable move in yen, which depreciated from low 80s to as high as 120s during 2013-end to 2015-end period (vs. USD). But the yen has reversed its course in 2016, appreciating from ~120 to ~100 today. It’s little unclear to us why the yen appreciated this year – perhaps it is perceived as safe heaven or investors might believe that there’s not much monetary easing “ammunition” left???

This recent appreciation of the yen could be a good set-up for buying out-of-the-money puts in the event that monetary easing continues, thereby possibly reversing the recent appreciation in the yen. But more importantly, a yen put would be a good insurance policy against Japan’s “bold” policy moves ahead, whether it be Helicopter money or some form of a larger monetary easing package. Although we’re not predicting or hoping for a breakdown of the yen, we’re aware of the risk and are considering an insurance policy in such a scenario. For simplicity's sake, we assume an upfront premium of $250k in each scenario. We show 3 and 6 month contracts, both on out-of-the-money puts struck at 115 and 120 (which is where yen was just 8 months ago). At 120, an investor would make ~15-42x payoff on 115 puts, and at 125 would ~27-57x payoff on 120 puts.

Please note that these are OTC products and, as such, require credit risk with counter party and an ISDA relationship. The pricing is as of Friday (8/19/2016), which should still be reliable as it’s on the out-of-the-money Yen option and Yen hasn’t moved much since then.

Yen per USD chart:

Yen put payoffs:

No reliance, no update and use of information. You may not rely on the information set forth in the above write­up as the basis upon which you make an investment decision. To the extent that you rely on such information, you do so at your own risk. The write­up does not purport to be complete on the topic addressed, and we do not intend to update the information contained therein, even in the event that the information becomes materially inaccurate. Certain information contained in the write­up includes calculations or projections that been prepared internally; use of a different method for preparing such calculations or projections may lead to different results and such differences may be material. We now own the position discussed above, and may decide to buy or sell such position at any time of our choosing without providing an update.

Catalyst

- September meeting

- Heighten concern about Japan's fiscal standing

- Accelerated intervention to weaken the yen