Lehman Brothers is recommending investors enter long U.S. dollar/Japanese yen implied volatility positions because volatility has dropped to its lowest level in more than a year. Anne Sanciaume, foreign exchange strategist in London, said "people rushed to buy volatility as an asset class [after Sept. 11] and it is true that things have not gotten worse, so people have been unwinding these long volatility positions." However, Sanciaume believes investors are over-confident and have gone back too far in unwinding these long vol positions. One-year dollar/yen implied vol was 10.3% last Tuesday, close to lows set last summer. Sanciaume considers fair value to be around 11.5%.
To take advantage of the lower implied volatility Sanciaume recommends buying a two-year in-the-money dollar call/yen put with a strike and knock out set at JPY115 at a 2.5% premium. Spot was at JPY121.50 last Tuesday. A plain vanilla options would cost approximately twice as much. In the trade investors win if the dollar appreciates. If spot moves to JPY123 in six months, the option would be priced at a 4.53% premium, she said. However, she said the value of the option would decrease if the dollar depreciated toward JPY115 and investors would lose all their premium if it hit the knock out at JPY115.
The trade is designed for sophisticated investors, most likely hedge funds, to take a punt on the market.