Struggling with a Strong Yen

Japan's new government continues to wrestle with the strength of the yen. Although previously as a finance minister Fujii seemed more sympathetic to intervention, he now wants to break from the past. While he has back tracked from his previous apparent endorsement of a strong yen, he is still setting the bar for intervention high. News wires quote him warning of an official response if the foreign exchange market is disorderly.

This is a slippery word, for sure, but by looking the options market one can get some sense of the state of the market. The first is implied volatility itself. There are two measure of volatility to consider. The first is actual volatility--of variance of the dollar-yen exchange rate. Today it is just below 9.9%, which is the lowest in more than a year.

The second is implied volatility, which is embedded in current option prices. The 3-month implied volatility, a benchmark measure, stands at about 14.25%. It is the upper end of where it has traded over the past month. To put this in perspective, it reached around 14% during the 9/11 period and reached a low of almost 6% in mid-07. A year ago it was near 30%. As recently as July it implied volatility was over 15%.

Another measure from the options market that is worth considering is the pricing of risk-reversals. The basic premise is put-call parity, which essentially states that puts and calls equidistant from the forward price have similar value. To the extent the prices are skewed it shows the market's bias.

Officially speaking, the BOJ has not intervened on dollar-yen since early 2004, but during its more activist days, the pricing of the risk-reversal would often be a useful in trying to anticipate intervention. Yen calls typically trade at a premium to yen puts, possibly due to the role of Japanese corporates, protecting foreign sales. The 3-month risk reversal favors yen calls by almost 3% today. While this is elevated, it is within the range seen in the past several weeks.

The bottom line, by indications from the options market, the dollar-yen rate remains largely orderly and the risk of intervention remains relatively low. Fujii's explanation that the yen's strength reflects dollar weakness, which itself is a function of low US interest rates would seems to underscore this point. It is not yen strength, but dollar weakness and intervention would go against interest rate fundamentals.

At the same time, Japanese corporations have been complaining louder about the strength of the yen. It is not simply dollar-yen that is their focus. The yen has appreciated nearly 15% against the Korean won for example over the past year and this appears to be giving Korean producers a competitive advantage over Japanese producers. Yesterday's earnings announcement by Samsung (operating profits more than doubled) will offers stark contrast to expressions of concern by Japanese electronics producers like Sony.