I will be out the office today, so instead of not posting, I dug up a piece I wrote a couple of years ago. At the time, Japan had just elected Prime Minister Abe. The markets were excited by the prospect that Japan might finally usher in the policies needed to put an end to the decades long deflation. All the interest in trading Japan reminded me of a time back in my youth when speculating on the end of the Japanese bubble was “the trade.” This is that story…

Nikkei Put Warrants – a blast from the past

Written December 26, 2012

With the election of Japan’s new Prime Minister, who campaigned on a pledge to dramatically alter Japan’s monetary and fiscal trajectory, there is a renewed interest by macro traders to short Japanese Yen and Japanese Government Bonds (JGBs). Although this trade has been popular at various points over the last decade, there is no doubt that macro traders are growing increasingly confident that this time the big decline has finally begun (again). All of this talk about the inevitability of the collapse in JGBs and Yen reminds me of the other hugely popular Japanese bear trade from three decades ago.

During the decade of the 1980s the Japanese Nikkei index experienced one of the truly great credit bubbles. At the beginning of the decade the index was trading at less than 7,000. At the turning of the decade, it had appreciated to just under 40,000.

http://themacrotourist.com/images/Azure/NKYEarlyMay1414.pngNikkei – straight up during the 1980s</a> </div>

During this period, most of the world financial community was enamoured with the Japanese business acumen. It seemed that the Japanese could do no wrong and they were destined to own the world. The Japanese economy managed to grow in any scenario and even the US stock market crash of 1987 did not derail the Japanese miracle (sounds vaguely like another modern day Asian country but that is a story for another day).

However, there were those who recognized that the Japanese miracle was nothing more than a massive credit bubble. In fact, in 1987 George Soros had actually shorted massive amounts of Nikkei futures and bought US stock index futures as a hedge, in the belief that the Japanese bubble would burst and the crash would start in Japan. He proved a few years too early, and the trade was a massive loser for him. But during the ensuing rise of the Nikkei stock index after 1987, many market participants continued to yearn for a way to short the inevitable bursting of the Japanese bubble.

In this environment, the Nikkei put warrant was born. If I recall correctly, the first put warrants were issued by Bankers Trust – who at that time was the preeminent derivatives dealer. The put warrants proved immensely popular as they were in essence long dated put options on the Nikkei index that traded during North American hours thus making it extremely easy for market participants to take a bearish view on the over priced Nikkei.

Before I continue with this story, I have to take a moment out to explain that I was not actually on an institutional trading desk at this time. During most of this period I was finishing high school and then headed off to University. However, I eventually ended up working for RBC Dominion Securities during the early 1990s and I was introduced to a fellow by the name of Doug Steiner who had also previously worked on the same institutional desk at RBC Dominion Securities where I had recently gotten a job. Doug is an extremely bright fellow (just ask him), with a very unique view of the world. I don’t think he would mind me telling you the story that he relayed to me about the Nikkei put warrants that RBC Dominion Securities issued.

Eager to profit what seemed like an over eagerness of North American investors to bet on the collapse of the Nikkei, RBC Dominion Securities decided that they too would underwrite some Nikkei put warrants. Somehow Doug convinced his superiors that issuing these put warrants was a great way to put DS (as everyone called RBC Dominion Securities back then) on the map in terms of derivatives and make some money as well (Doug is nothing if not convincing). I can’t remember the actual volatility numbers, but in essence DS figured they could sell these long term warrants at 25% volatility and earn a tidy profit by maintaining a dynamic hedge which would hopefully be realized at 15% volatility (or some other low number like that). The gist of the trade was that North American investors were over paying for Japanese Index volatility because they would so eager to bet on the demise of the Nikkei. Doug was going to profit on this desire and issuing the DS put warrants was the perfect trade…

Or so Doug thought.

After dancing through the underwriting hoops and selling the product to DS’ large retail brokerage community, the put warrants were listed on the Toronto Stock exchange. Doug and his group of young derivative experts put on the initial hedge by shorting the calculated number of Nikkei futures in Japan. The first night was a great thrill. Staying up late to trade in Japan seemed very romantic. Not only that, the deal was a monster success and DS was well on its way to staking its ground in the newly burgeoning derivatives market.

But then reality quickly set in. Investors proved correct in their prediction for the demise of the Nikkei. The index very shortly thereafter rolled over, and the selling accelerated.

http://themacrotourist.com/images/Azure/NKYDemiseMay1414.pngNKY rolls over and heads straight south</a> </div></p>

The volatility, which had thus far been somewhat subdued by the relentless bull market, went through the roof.

Doug and his group were now faced with the task of dynamically hedging an increasingly volatile, quickly collapsing, stock index in another part of the world. What had seemed so romantic now quickly became a chore as every night was filled with the need to buy and sell Nikkei futures as the index zinged around. For those who aren’t familiar with option hedging, as the probability that the warrants that DS had underwritten were going to expire in the money increased, DS was forced to short more futures. If the index rallied back, the probability would decrease, and the hedging model would dictate that DS would buy the futures back. If the index was really volatile, as it was increasingly becoming, it would make sense to hedge the position several times throughout the trading day. The problem was, the trading day in Japan was the middle of the night in Canada. Doug and his group were increasingly staying up all night to trade in Japan, but they still had their jobs during regular North American hours.

Sometimes while sitting on the trading floor in Toronto hedging their positions during the evening, the members of the group would zip down to the bar in between orders for a few drinks. One night there was way more drinking than trading going on. At the end of the evening, they all piled into Doug’s porsche – even though they barely fit – someone was practically lying down across the back seat with two guys in the front passenger bucket seat beside the driver. Wouldn’t you know it, but they were pulled over by the police. Doug proceeded to explain to the police officer that they were all traders at a big investment bank and they were up late hedging their Japanese index positions. In his usual fashion, Doug managed to talk his way out of this situation without getting a ticket.

As you might surmise from my story, Doug is quite a character. Although he is sharp as a tack, I think his true genius lies in his ability to think outside the box.

Faced with hedging this position every night for the next 3 years of the put warrants life, Doug needed to figure something else out. What had sounded like a lot of fun was quickly becoming an all night affair – each and every night.

In telling me the next part of the story, a big smile appeared on Doug’s face. You see, a decade later he had met up with the fellow that was responsible for hedging the BT (Banker’s Trust) put warrant positions. This fellow had had the same problems as Doug, except that BT had issued even more warrants, with different strikes and more complexity. The BT trader proceeded to tell Doug how the pressure and hours from trading those positions ruined his marriage and ultimately resulted in him getting divorced. He went on to tell Doug how it was the worst part of his life and that he deeply regretted ever coming up with the idea of issuing those warrants.

“I didn’t have the heart to tell him” Doug said to me as he explained it.

“Have the heart to tell him what?” I asked.

“That instead of continuing to hedge the position every night, I simply bought enough of his warrants on the open market to offset my position…”

Doug had figured out that the BT warrants were trading cheaper than he was able to achieve by dynamically hedging, so instead of continuing to trade every night in Japan, DS simply covered their exposure by buying up the BT warrants in Toronto. The hedge was much easier to maintain as the BT warrants had very similar characteristics to the DS put warrants. Doug had figured out that instead of trading in Japan, it was much better to simply buy the product in North America and let BT do all the work dynamically hedging all night long in Japan.

I don’t have any deep insight with this story except to highlight that there was indeed another time when investors were convinced that a Japanese asset class would crash. In that case, the herd of North American speculators did indeed prove remarkably correct. That crash went on longer and deeper than anyone would have imagined at the time.

Today, I am only sure of one thing… I sure wouldn’t be underwriting any JGB or Yen put warrants… I wonder, what is Doug up to these days?