COMMENT-Option charts highlight extent of impending USD/JPY risks

They say a picture is worth a thousand words, and various option charts highlight the extent of perceived risks to USD/JPY from this forward looking derivative.

Volatility is an unknown, yet key parameter of an option premium, so dealers use implied volatility as a substitute. Any disparity between implied and realised volatility becomes tradable. By comparing past realised (historical) volatility with current implied rates, traders can discern whether future movements are expected to exceed historical patterns within a similar time frame.

Leading up to the Bank of Japan's decision, implied volatility for sub-1-month expiries soared to 2024 peaks, signalling heightened concern over potential excessive realized volatility. Although there was a brief decline in implied volatility following the BoJ's decision not to tighten policy or intervene to weaken the JPY, it swiftly escalated to previous highs amidst a dramatic drop and recovery in USD/JPY. This quick rebound underscores the market's anxiety and the effectiveness of options in capturing such moves.

The benchmark 1-month expiry implied volatility now trades at its highest premium to 1-month historical volatility since 2022. Additionally, 1-month 25 delta risk reversals, which indicate the implied volatility differential between JPY calls and puts, are at long-term highs for buying JPY. This is notable even as USD/JPY reaches new 34-year highs, reflecting the intervention risk premium embedded in these option prices of late.