Equity Derivatives Review
Nikkei - JPY correlation breaking down?
Derivative/Quant Strategy
Michiro NaitoAC
(81-3) 6736-1352
michiro.naito@jpmorgan.com
Yuichi Ito
(81-3) 6736-8616
yuichi.ito@jpmorgan.com
JPMorgan Securities Japan Co., Ltd.
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Equity Derivative Sales
Steven Devine
(81-3) 67368722
steven.j.devine@chase.com
Tom Summersall
(81-3) 6736-8808
Tom.a.summersall@jpmorgan.com
Rie Takagi
(81-3) 6736-8721
rie.x.takagi@jpmorgan.com
Delta One Products/Equity
Finance
Peter Lindsey
(81-3) 6736-1963
peter.s.lindsey@jpmorgan.com
Hendrik Warntjes
(81-3) 6736-1358
hendrik.g.warntjes@jpmorgan.com
Hitoshi Kikuchi
(81-3)6736-9317
hitoshi.kikuchi@jpmorgan.com
Keishi Mitsuda
(81-3)6736-8740
keishi.x.mitsuda@jpmorgan.com
Highlights of the Week
?Market: After breaching the post-bubble low, the TOPIX remained in a narrow
range the rest of the week. The market抯 calm is well reflected on implied
volatilities, as we have seen virtually no change in the Nikkei skew or term
structure over the last one month. While the equity market showed little
movement, the currency was on the move, with USD/JPY rising to levels not
seen in three months. As we approach fiscal-year-end in Japan, we note that the
month of March has generated most volatility spikes since 2000.
?Nikkei ?JPY correlation breaking down? While the sudden weakness in the
JPY was unexpected, the reaction by the equity market was surprisingly muted,
possibly signaling a break-down of the hitherto strong correlation between the
USD/JPY and Nikkei 225 (see Feb 20 report, 揘ikkei ?USD/JPY correlation to
break down,?by Tohru Sasaki). We find it curious that the timing of the JPY
weakening coincided with the announcement of the Japan's abysmal Q4
CY2008 GDP (minus 12.8% annualized). In our view, what we witnessed last
week was a 搒ell-Japan?phenomenon, where the currency and equities were
sold at the same time. We obviously do not know how long this trend will
continue. We also consider it possible, although not very likely, that a "buy-
Japan" campaign will begin if the Japanese government announces a meaningful
measure to support the equity market. Either way, we may soon see the end to
the high Nikkei - USD/JPY correlation, as we did in 2000, 1998, or 1993.
?Sell Nikkei JPY straddle - Buy Nikkei USD/JPY straddle: One way to profit
from the possible breakdown of the Nikkei-USD/JPY correlation is to sell
Nikkei JPY ATM straddle and simultaneously buy Nikkei USD/JPY ATM
straddle. The high Nikkei-USD/JPY correlation over the last few years has
caused the volatility spread between the JPY Nikkei and USD Nikkei to widen,
which will reverse if the correlation falls. At present, investors stand to collect a
3.5% premium upfront on a 6-month structure, 4.8% on a 12-month, and 5.7%
on a 18-month structure. The structure is Nikkei-delta-neutral and thus if the
correlation is unchanged, investors will stand on the upfront premium, and if the
correlation falls, investors should gain from the higher volatility on the long side.
If the correlation rises further, however, investors may lose on the trade.
?Cash-rich companies: Since the market began to bear witness to the precipitous
fall, investors have scrambled to look for defensive characteristics in companies.
This week, we focus on 揷ash-rich?companies. 揅ash-richness?potentially
shields companies from future financing needs or dividend cuts. We define
揷ash-richness?as cash/(debt + market cap) and provide screened lists in this
publication.
Note: Since options are a decaying asset, investors who purchase options risk
losing the option premium paid to purchase the option(s). Options are not
suitable for all investors.