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Analysis - Carry Trade Unwinding Risks 1998-style Dollar Fall

LONDON, Oct 9 - A potential investor exodus from option-related yen carry trades is threatening to trigger a 1998-style precipitous drop in the dollar with currency options prices already showing unprecedented demand for yen upside.

In carry trades, investors borrow yen at low cost to buy higher-yielding assets abroad. A lot of traditional yen carry trades have already been closed out as U.S.-Japan interest rate differentials narrowed and the trades became less profitable.

But the dollar's five-yen decline since a G7 call for more flexible exchange rates on September 20 is triggering hedging on longer-dated option-related yen carry trades which were profitable as long as the dollar went up or stayed in a range.

These leveraged trades use long-dated options beyond 20 years. Because these long-term options markets are highly illiquid, signs of panic are already emerging in options prices and hedging the positions could ultimately result in selling dollars in the spot market.

"As spot dollar/yen falls, the market is looking for protection in long-dated options and is willing to pay a very high price. But the long-dated market is not liquid. So once dollar/yen starts to fall people are having to hedge in a thin and panicked market," said Giovanni Pillitteri, vice president on the options trading desk at Deutsche Bank.

"They will move down the line (from long-end to short-end) and ultimately they will be forced to sell dollar/yen to hedge."

Major unwinding of traditional yen carry positions in the aftermath of the 1998 Russian default and the collapse of hedge fund Long Term Capital Management shaved a quarter off the dollar's value in just four months.

Risk reversals, a widely used indicator in the options market which gauges investor sentiment towards a specific currency, are showing a record skew towards the yen's upside, beyond levels seen in the 1998 crisis.

Only a fortnight ago, one-year risk reversals hit an all-time high above three percent favouring yen calls, which give the right to buy yen, and have stayed near that level ever since.

"It's such a one-way market," an options dealer at a London-based bank said.
The longer-dated options market is still very illiquid and Pillitteri said it was only over the last year that a two-way market in 10-year options has developed.

Eric Ohayon, European head of FX structuring at Bank of America said: "The market remains exposed to the (dollar) downside... but it is likely to be expressed through the options market rather than the spot given the threat of potential intervention."
"(But) Once barriers are broken, you suddenly find yourself having to sell spot to cover those positions, and it becomes a self-fulfilling prophecy," he said.
Japanese authorities have intervened heavily this year to keep the yen from gaining on the dollar but since the G7 statement they appear to have become less aggressive.

1998 AGAIN?
By August 1998, demand for lucrative yen carry trades had helped propel the dollar to a peak of 147.63 yen from a record low three years earlier. The total amount of yen borrowed by speculators was estimated in mid-1998 to have reached 15 trillion ($137.5 billion).

The dollar then lost nearly 33 yen, a quarter of its value, in just four months as extreme risk aversion resulting from the crisis triggered major unwinding of those trades. Dealers say longer-dated structured notes, such as Power Reverse Dual Currency bonds (PRDC), gained popularity in the 1990s as Japanese investors sought higher-yielding carry trades because domestic interest rates were near zero.

PRDCs, whose average maturity is around 27 years, link the coupon to FX rates. The first coupon is fixed and subsequent coupons are then proportional to the dollar/yen rate.

The coupon becomes larger if dollar/yen is higher on the coupon date. Conversely, the coupon becomes smaller if the dollar/yen is lower on the coupon date. Deutsche estimates the market size of PRDCs is four to five trillion yen.

"Investors are betting dollar/yen will go up or at least not go down. If dollar/yen falls, swap houses (with which the issuers with PRDCs hedge their cashflow) will need to hedge their exposures, ie buying back long-end volatilities," Pillitteri said.

"It could reach a point where there is no supply anywhere in the options market to offset the demand for hedging. Ultimately, they will have to sell dollar/yen in the spot market."

By Natsuko Waki
Source: Reuters News Service

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