TOKYO: Investors in Japan's debt markets are betting through the options markets that the central bank will succeed in containing government bond yields within its desired ranges.
That strategy involves selling options on Japanese government bonds (JGBs), earning income from any buyers who want the right to buy or sell JGBs at a later date.
Traders are selling both kinds of options -- call options to buy bonds and put options to sell them -- on the view that the price, or premium, will collapse as JGB yields get boxed into a tight range.
At its Sept. 21 policy review, the Bank of Japan set a new target of keeping the 10-year JGB yield at around zero percent, while dropping its explicit 3-1/2-year-old target for the amount of bonds it would buy from the markets.
That was a major shift for a central bank that has tried in vain for years to reflate the economy and escape deflation through quantitative easing. The BOJ said its aim was to anchor the yield curve so that inflation expectations are also lifted.
While the market was initially unsure exactly what the BOJ meant by "around zero percent," its market operations since then have led many players to believe the BOJ's rough target band for 10-year JGBs would be between zero and minus 0.10 percent.
The price of JGB options, which gives holders the right to buy or sell JGBs at a pre-fixed level, has fallen sharply after the BOJ rebooted its policy last month.
As investors rushed to sell options, implied volatilities, a measure of investors' expectation of future volatility which is derived from option prices, have fallen sharply over the last several days.
The volatility for 10-year bonds is now quoted around 1.2 percent, compared to around 6 percent before the BOJ's meeting, said a bond option trader at a major Japanese brokerage.
"Options traders are now in heavy demand from investors. Everyone wants to sell options to us," the trader said.
Market players say the volatilities are now at one of the lowest levels in recent years.
The implied volatility on the 10-year JGB futures also fell below 1.3 percent, falling near lows touched in June.
That is almost a half of the market's actual volatility of 2.3 percent over the past year, indicating investors expect the market's volatility will drop almost by a half in coming months.
Trying to control the 10-year bond yields, which tend to be influenced by several factors including the global economic outlook, is an unprecedented approach, and analysts are not sure whether the BOJ will be able to achieve its objective.
But the BOJ is the dominant player in the JGB market because of the massive amounts of bonds it buys under its stimulus programme, which is why options market participants are betting yields will stay contained for now.
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