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BEN MELKMAN & MICHAEL GREEN

INTERVIEW CHEAT SHEET by Michael Green

How you structure a trade in the option market for yen in 2012 with a knock-out USDJPY
call:

Forward space the prices of any good (commodity/interest rate/currency/equity


index/etc) at forward (future) points in time. These are calculated as non-arbitrageable
levels that compensate an investor for commodity storage costs, differences in interest rates
of different maturities, interest rate differentials between countries and dividend yields,
respectively. There exists an empirically dubious hypothesis that these forward prices
represent unbiased forecasts of future spot prices, but this requires the efficient market
hypothesis to hold.

In currencies, the country with the higher interest rate must have a lower currency price in
the forward market, otherwise an investor could hedge the currency in the forward
market and earn a higher than risk-free yield with no additional risk. As always,
Wikipedia is a good source for further information
(https://en.wikipedia.org/wiki/Forward_exchange_rate)

A knockout call option on dollar-yen (long dollar/short yen) is a long-dated call option
on the US dollar vs Japanese yen (in this example 2 to 5 year calls) that knocks out (you
lose the option and your premium) in the event that the knock out barrier is breached. In
this case, Ben took advantage of two features of the $/yen. First, because US interest rates
were (and are) higher than Japanese interest rates, the forward price for yen was stronger
(USD lower/JPY higher) than the spot price. The value of the option must be calculated off
of the forward price, again to avoid violating non-arbitrage conditions. Second, due to
the negative correlation between yen and global risk assets (yen rallied when global risk
assets fell), there was much stronger demand for yen calls than for yen puts creating skew
differential. By structuring his call so that it knocked out in the event that the yen
appreciated by approximately 5-10%, an event that the market structurally placed high
probabilities on, Ben could bet on a weakening yen at discounted prices.

Option space prices of securities as implied by the derivatives markets

A worst of option is a basket option that pays the investor the minimum payout of three
separate options on three different underlying assets. If the expected correlation between
these assets (e.g. Nikkei, S&P, and EuroStoxx) are high, then the combined basket will
trade close to the price of each single options. However, if expected correlations are low,
then the basket will trade at a steep discount to the single option. The difference between
the pricing of the single options versus the basket is hence a measure of expected
correlation and therefore a correlation trade. A trader anticipating that correlations in
the future will be higher than the market is pricing could sell the single options and buy
multiple basket options.

What is a Sterling 15 year 15 year? The Sterling refers to the British pound and 15
year 15 year is a forward interest rate derived by calculating the 15 year interest rate 15
years from now. Since a 30 year bond is the combination of holding a 15 year bond to
maturity and then reinvesting the proceeds into a new 15 year bond, we can calculate the
15 year 15 year (written as 15y15y) as the level of future interest rates that solves for
the combination of current 30 year and 15 year bonds in the UK in this case 1.5%. Ben
is pointing out that this 15y15y is implying negative real yields for the pound basically
forever, which seems inconsistent with the positive expectations embedded in current equity
markets.