Continuing on from the previous post where I mention USDJPY behaving as if a bank is strongly defending a barrier at 100, I hope to clarify what this means for those who may not know a great deal about barrier options.
Supposing a bank has sold a 'One-Touch 100' option worth 20mio USD to a customer who believes 100 will be broken before a certain date. This means exactly what it says on the tin - the customer will receive an instant payout of 20mio USD should 100 break. From the bank's perspective, then, they have a strong incentive to avoid 100 being touched. Traders and management at the bank may decide the risk-reward of putting in a large offer around 9980 is attractive.
Let's say they put up an offer in size of 500mio at 9980. That is probably large enough to withstand all but a concerted effort by other banks or funds to break the barrier, since algorithms and other traders will often show offers more readily below 9980 knowing that there is a large offer behind them. How much is the bank risking? If they get lifted, the price will very likely gap - but in a liquid market like USDJPY, they should be able to get most of their money back by a big figure at most. Let's assume the worst case scenario occurs and they lose 1 figure on 500mio - that's a $5mio USD loss. The flipside is when they successfully defend, they get the full payout of $20mio. At a 4:1 payout ratio for worst vs best case, and with the worst case in all eventuality having less than a 20% probability of occurring if executed correctly, you can see why it makes sense for the bank to defend vigorously.
In reality banks rarely have such outsize 'pin risk' on their books completely unhedged, but the pace at which USDJPY has appreciated in the last month certainly makes it possible that some banks have been caught off guard. In my opinion, the option probably expires by the end of this week, for two reasons. One, the longer you try to defend a barrier the greater the risk of failure, so it's unlikely the life remaining is very long anyway. Secondly, Golden Week - a series of Japanese national holidays - starts next week and most customers will avoid paying for an option that includes these much quieter days. The week before Golden Week begins seems like a natural time to set as the end of an option.
Supposing a bank has sold a 'One-Touch 100' option worth 20mio USD to a customer who believes 100 will be broken before a certain date. This means exactly what it says on the tin - the customer will receive an instant payout of 20mio USD should 100 break. From the bank's perspective, then, they have a strong incentive to avoid 100 being touched. Traders and management at the bank may decide the risk-reward of putting in a large offer around 9980 is attractive.
Let's say they put up an offer in size of 500mio at 9980. That is probably large enough to withstand all but a concerted effort by other banks or funds to break the barrier, since algorithms and other traders will often show offers more readily below 9980 knowing that there is a large offer behind them. How much is the bank risking? If they get lifted, the price will very likely gap - but in a liquid market like USDJPY, they should be able to get most of their money back by a big figure at most. Let's assume the worst case scenario occurs and they lose 1 figure on 500mio - that's a $5mio USD loss. The flipside is when they successfully defend, they get the full payout of $20mio. At a 4:1 payout ratio for worst vs best case, and with the worst case in all eventuality having less than a 20% probability of occurring if executed correctly, you can see why it makes sense for the bank to defend vigorously.
In reality banks rarely have such outsize 'pin risk' on their books completely unhedged, but the pace at which USDJPY has appreciated in the last month certainly makes it possible that some banks have been caught off guard. In my opinion, the option probably expires by the end of this week, for two reasons. One, the longer you try to defend a barrier the greater the risk of failure, so it's unlikely the life remaining is very long anyway. Secondly, Golden Week - a series of Japanese national holidays - starts next week and most customers will avoid paying for an option that includes these much quieter days. The week before Golden Week begins seems like a natural time to set as the end of an option.
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