Hedging S&P with USDJPY Options - Natixis

Su Young Lee, Research Analyst at Natixis, suggests that with an 11% rally of the SPX since the election of Donald Trump and strong valuation multiples (12M-Fwd PE is over 17 according to IBES data), the risk of an equity correction has de facto increased.

Key Quotes

“Despite a stubbornly low VIX, the price of S&P puts has indeed increased significantly  as depicted by the increase in the skew of the index. Hence, the need to look for alternative hedges in case of a hectic episode in the equity market.”

“Since the BoJ launched the unprecedented monetary and fiscal stimulus program, aka “Abenomics”, the JPY took a special role: instead of remaining a domestic market condition indicator, JPY became the barometer for global market liquidity and sentiment (risk-on vs. risk-off), and has turned as an emblematic safe-haven currency.”   

“The correlation between USDJPY and SPX has been mostly positive during the past decade. During acute downside movements in SPX, such risk-off sentiments turn into a flight to safety, hence lower USDJPY.  The correlation during strong risk-off events are depicted by the two charts below: using either daily or weekly returns, the correlation increases up to 70%-80% during extreme S&P losses, whereas it remains moderately positive otherwise.”

“Currently the correlation is at lower range and rolling beta is also at lower than average range, as low VIX and high S&P 500 have remained supportive. However with USDJPY virtually floored at 100, the level that the BoJ is believed to defend in the case of a massive flight to safety, even very high correlation during risk off will make it difficult for the currency to see drastic loss.”

“Bottom Line: given the current level of correlation and the risk of market correction, we propose the following trade idea using a self-financing strategy:      

• Sell SPU7 2,448 European Call (5% OTM). Maturity = 6 months.     
• Buy USD Put / JPY Call Down-and-out. European Strike = 111.5, American KO Barrier = 99. Maturity = 6 months.     
• Zero premium”  

“Rationale:

As the VIX is currently at historical low, so is correlation between SPX and USDJPY. This trade could be profitable in both risk-on or risk-off scenario: 

• if the market remains in risk-on mode and SPX continues its grind higher, in a low/negative correlation regime USDJPY could go lower and thus the long USD puts be in the money.  
• -on the other hand, if the market goes into a sustained risk-off mode, then the VIX would rebound, JPY would regain its safe haven status, pushing correlation higher. SPU7 calls would expire worthless, whereas the long USD puts would be in the money (hopefully not being knocked out at 99).”