During the COVID pandemic, central banks worldwide adopted zero interest rate policies to cushion the blow to the real economies. Some even adopted negative interest rate policies to try and jumpstart economic activities. As the pandemic uncertainty faded, inflation rapidly replaced it as the top concern. Central banks worldwide then turned to progressively tighter policies to try to combat it to various degrees.

With Japan marred in the decades long doldrum, the Bank of Japan (BOJ) was virtually the lone holdout in the race to higher interest rates. As a result, the interest rate differential between Japanese yen and other major currencies widened to levels not seen for quite some time. During which the Japanese yen has tumbled to a 30-year low against the USD and other major currencies – and perhaps with no end in sight in its depreciation, despite the BOJ exiting eight years of negative rates in March 2024.

As a result, Japanese assets suddenly appeared to be cheaper relative to assets in other economies, reviving interest in them. The Nikkei 225 index finally reclaimed its historic high from some 35 years ago, even breaching the historic 40,000-mark and set new historic highs, joining S&P 500 and other equity indices in developed countries in setting records this year.

With the BOJ walking a tightrope on managing the domestic inflation and economic performance while keeping an eye on its currency strength, the outlook of both the currency and the Japanese stock market would be facing much uncertainty. The suite of Nikkei 225 Index futures at CME Group provides an excellent set of tools to help market participants manage their exposure to the Japanese equity market.

Two main versions of Japanese Equity Index futures traded at CME Group are respectively the yen-denominated Nikkei 225 Index futures (Globex code:NIY) and USD-denominated Nikkei 225 Index futures (Globex code: NKD). Exhibit 2 summarizes the contract specification for the two contracts.

^{Source: CME Group}

Investors can benefit from an embedded currency-hedge via quanto index futures. They can be used for issuers hedging structured product flows and transfer risk for products which separate the performance of equities from the FX movements. Counterparties include banks, asset managers and hedge funds. Nikkei 225 Index futures are exchange traded and centrally cleared, providing independent mark-to-market valuation and transparency. Furthermore, as centrally cleared solutions, they are preferred by most market participants as it avoids counterparty risk and trading across time zones.

Exhibit 3 charts the average daily trading volume for the two contracts since 2020.

The key important takeaway from the contract specification is that both versions of the contracts, notwithstanding the different currency in the contract multipliers, are based on the same underlying Nikkei 225 Index. Which is calculated based on the prices of the constituent stocks denominated in JPY. This means both contracts at the expiration would be settled in cash to the same index level of the Nikkei 225 based on the yen-prices of the constituent stocks.

Because index futures are “unfunded instruments,” market participants are not exposed to currency risk associated with the notional value of the futures per se. Since the performance of a futures position is determined by the entry and exit pricing on the futures trades, one can reach the conclusion that there is no currency risk on the principal amount of the trade. By considering the following scenario: If the value of the Japanese yen were to fall by half while the index level stays unchanged, since there is no change in the index level, the profit-and-loss associated with the futures trade is roughly zero regardless of what currency multiplier and thus which version of the futures is used. In fact, the example of the fall in Japanese yen by half does not come into play in this scenario.

A different way to consider this is that when the futures contract is bought, the delivery of the underlying asset is set for a futures date at a yen price that is fixed now. That yen proceeds fall in value will also lower the eventual delivery price denominated in USD. Since there is no currency conversion at the inception of the futures trade, the participant is not exposed to the currency risk.²

As such, the two versions of the Nikkei 225 Index futures generally track each other except for a “small” price differential between the two. Exhibit 4 shows the price history of the front month USD and yen denominated Nikkei 225 Index futures (NKD and NIY respectively), as well as the price differential between the two. Since the two versions of the contract settle to the same index value at the expiration, the spread between the two converges to zero at that point.

It can be seen in Exhibit 4, that the USD denominated Nikkei 225 Index futures trade at premium to its yen denominated counterpart. The positive premium decays over time until it hits zero at the expiration. The regularity of this pattern hints at a more “structural” reason for its existence rather than happenstance.

Over the last few decades, there has been a visible correlation between the USDJPY exchange rate and the Japanese equity market in general. When the market is in a “risk on” mode, both the global equity markets and USDJPY tend to rally together. Conversely, when the market toggles over to a “risk off” mode, both global equity market and USDJPY tend to fall together as well.³

In light of this correlation pattern, it might be more advantageous to hold USD denominated Nikkei 225 Index futures vis-à-vis its yen denominated counterpart. In the scenario of the Nikkei 225 index rising, USD tends to also gain versus JPY. The value of the gain in long USD-denominated Nikkei 225 Index futures (NKD) outperforms that of a long position in the yen-denominated Nikkei 225 Index futures (NIY). Conversely, when the equity indices fall, USD tends to also weaken versus JPY. The value of the loss in a long NKD position tends to be smaller than that of a long position in the NIY contract. Since NKD tends to outperform NIY regardless of the market direction, it follows that the former should be worth a higher price than the latter. 

This is indeed the case, as Exhibit 4 shows. NKD has been trading at a premium to NIY, with the price differential decaying to zero at the contract. Furthermore, the “fair spread” between NKD and NIY can be characterized by the following formula:

The key determinants in the fair value of this quanto spread depends on the volatility of the Nikkei 225 Index, the JPYUSD currency pair as well as the correlation of the equity and the currency movement.

For a full exposition on how this formula is derived and how the spread trade is constructed, consult the companion piece to this article: Nikkei 225 Spread Opportunities.

The implied correlation is defined as the ratio between the magnitude of the premium and the implied volatilities. This can be used as an indication of whether the end users in the NKD Nikkei futures value the dollar denomination so much that they are willing to pay beyond “fair-value.”

The stronger the correlation is and the more volatile the market is the wider the price spread should be. This spread is also known as the “quanto spread.”  

Exhibit 5 plots the history of the implied correlation history of the NKD contract (dotted line). The implied correlation for the December 2023 contract, for example, is derived from the difference between the calendar spread of the NKD futures vs that of the NIY futures during the Sep-Dec roll period. The bold line in exhibit 5 shows the realized correlation between Nikkei and USDJPY during the period when Dec 2023 futures was the front month contract i.e. the period between the Sep 2023 and Dec 2023 expirations. This is repeated such that the series of quarterly rolls is then reconstructed.  

The following chart depicts the three-month implied volatility of the exchange rate and the three-month implied Nikkei 225 Index volatility while the left axis illustrates the spread differential is the difference between the calendar spreads in terms of index points of front and next quarterly months in NKD and NIK Nikkei 225 Index futures.

_{Calculations based on the closing settlement prices 8 trading days before expiry.
Roll period defined as the final 8 trading days of the expiring contract. Nikkei 225 Index contracts, on a quarterly basis, expire on the Thursday before the second Friday of the expiration month.
The NKD/NIY Differential is the VWAP (Volume-Weighted Average Price) of the quarterly spread trades.
FX 3-month implied volatility is calculated using USD/JPY ATM options.
Index 3-month implied volatility is calculated using end of day Nikkei 225 Index at the money index option prices.
Source: CME Group, Bloomberg}

Exhibit 5 illustrates that the implied correlation and the realized correlation track each other fairly well over the course of the last decade. One can surmise that the market appeared to have priced the quanto spread correctly.

If one subscribed to the theory that the yen carry trade drives the correlation, the decline of the correlation made sense. For most of the period covered in this chart, the Japanese interest rate was markedly lower than the U.S. interest rate. Thus, the incentive to pursue yen carry trades existed. However, during the COVID pandemic most central banks worldwide aggressively kept interest rates close to zero, for the period between 2020-2022. With no interest rate differential, the incentive for yen carry trades disappeared. As such, one should not expect the mechanism that creates the correlation between risky assets and JPY to present opportunities. It was borne out by the realized correlation during this period.

With the central banks globally shifting policy to tackle inflation concerns, the interest rate differential over JPY rate reemerges. As such opportunities in the yen carry trade may present themselves and with it the possibility of the correlation emerging. The realized correlation after 2022 in Exhibit 5 seems to hint at a possible uptick in that regard.

Constructing a quanto position necessitates executing trades in both the NKD and the NIY contracts simultaneously. The Nikkei 225 Spread Opportunities article provides further details on how to determine the spread ratio between the NKD and NIY legs.

In brief, the notional value of the NKD leg and the NIY leg of the spread should be identical. At the time of writing, USDJPY is around 156, the spread ratio is 100 NKD:156 NIY, or 2:3 ratio approximately.

There are various and different ways to execute the trades on either on block or screen via CLOB (central limit order book), example includes:

1. Executing the two legs separately. While it is always possible, it will depend on the depth of the order book. There is a risk of the pricing on the two legs diverging as the size of the trade increases. In order to mitigate the trading risk, block trades for each leg might be considered in this scenario.
2. Executing the calendar spread trades on NKD and NIY – during the quarterly roll period, the calendar spread market is very liquid. Larger trades can be executed without appreciable price impacts.

Exhibit 6 shows a screenshot of the NIY and NKD calendar spread market. When executing a calendar spread, by default, the nearby expiration is priced at the previous day’s settlement price and the deferred expiration is priced relative to that.  With the calendar market at 1-tick wide for both NIY and NKD with available quantity of 8,561 x 3,249 and 194 x 168 respectively, a trade of 150 NKD: 234 NIY (approximately $29 million in notional value for both legs) can be executed at the top of the book with no slippage. Since the calendar spread market is much less volatile, it is likely that much larger trades can be assembled sequentially at the same prices.

Following the trade, quanto spread positions in both the nearby expiration and the deferred expiration will be established in the same quantity but in opposite direction.  Since the nearby contract will expire at the end of the roll period, only the quanto spread position in the deferred expiration will remain. In the interim, the ratio can be managed using the calendar market as well.

Enhanced trading functionality includes the following:

3. BTIC - Basis Trade at Index Close
   Executing BTIC trades on NKD and NIY. When executing a BTIC trade, the futures index cash basis is agreed. Following the close of the Japanese equity hours once the closing value of the Nikkei average has been established, the futures position is then priced at the cash index close plus the agreed upon basis. Since NKD and NIY BTICs reference the same cash index close level, one can see this is analogous to using the calendar spreads, except that only one expiration of each futures leg will be established. 
   Market participants can continue to use BTIC trades in NIY or NKD to adjust the spread ratio until the close of Japanese trading hour, with all the executed BTIC trades resulting in leg prices determined by the same cash index close level on the same day.
4. ICS - Inter-Commodity Spread
   Using the Implied Spread order book – CME Group introduced implied spreading between NIY and NKD futures on Globex, effectively linking the two outright order books with the NKD-NIY spread.
   The NKD-NIY spread is a predefined 1:1 spread in the spread order book. Buying the NKD-NIY will result in long NKD and short NIY at 1:1 ratio. If a buy order in NKD-NIY is matched with an outright NKD sell order and an outright NIY buy order, the leg prices will obviously be determined by the prices of the two outright orders. Else, if a spread buy order in NKD-NIY is matched to a spread sell order, the more recent of the last outright trades in NKD and NIY will provide the leg price of the spread order match.
   For more details of how implied spread works, read the dedicated article Nikkei 225 Implied Intercommodity Spreads. Exhibit 7 shows a screenshot of the NKD-NIY spread order book. 

Given the fact that the spread book is pre-defined at 1:1 ratio, executing quanto spreads with the correct spread ratio would require completing the tail quantity in the outright order book. For example when executing a 10 NKD:15 NIY trade, the 10 spread execution will leave 5 NIY contracts unexecuted. It will need to be executed in the NIY order book following the pre-defined spread execution. This implied spread order book route entails some leg execution risk.

With the Nikkei 225 Index reaching all-time highs, the reemergence of the USD-yen interest rate differential, the depreciation of yen versus most currencies and the realized correlation ticking higher between the Nikkei 225 Index and USDJPY all could present potential opportunities in the yen carry trade.

Trading in CME Group Nikkei 225 Index futures complex becomes more interesting.

The opportunity to trade the quanto spread and capitalize on the correlation between USDJPY exchange rate and the global equity market on a cleared venue is unique.

With both NKD and NIY legs marked to market every day at the same time, and a liquid Japanese Yen futures at CME Group to help manage the exchange rate risk in the variation margin, it is a one-stop solution that is unmatched anywhere else in the world. 

Trading execution can be achieved either on block or screen via CLOB (central limit order book), example includes:

• Executing the two legs separately,
• Executing the calendar spread trades on NKD and NIY,
• BTIC: Basis Trade at Index Close,
• ICS: Inter-commodity Spread.

With both contracts as well as other CME Group Equity products’ liquidity around the clock, especially during non-Japanese hours, the product provides opportunity for investors to execute on worldwide allocation decisions at any hour as opposed to waiting for the local market to execute the individual pieces.

To learn more about the products, please consult the following resources in the appendix

Nikkei 225 Index

The Nikkei 225 Index consists of 225 blue-chip common stocks listed on the First Section of the Tokyo Stock Exchange (TSE). The Nikkei 225 Index is a price-weighted equity index which is denominated in yen. Like the Dow Jones Industrial Average (DJIA), the Nikkei 225 is a price-weighted index calculated by summing up the prices of all constituent stocks adjusted by presumed par values and dividing the summation by a divisor which changes from time to time to maintain the continuity of the index in cases of stock splits, reverse splits, component changes, etc. The components of the index are reviewed once a year. As of 18 June 2024, the Nikkei 225 Index has a market value of approximately yen $701 trillion, equivalent to USD 4.5 trillion.
(https://indexes.nikkei.co.jp/en/nkave/archives/data?list=tmc).

Japanese yen versus U.S. dollar exchange rate

The JPY-USD exchange rate is typically quoted in terms of yen per one dollar and this is commonly referred to as the USDJPY rate. For the convenience of USD-based traders, however, we quote in “American terms” of U.S. dollars per one Japanese yen. This is referred to as the JPYUSD rate. This further sets the stage for a discussion of how one might use JPYUSD futures, quoted in dollars per yen, as a hedge.

References:

¹ In Q1 2024, 75% of Nikkei 225 index future trades occurred outside of Tokyo cash hours, highlighting the CME Group as a venue to hedge overnight risk after Tokyo market closes.

² Note that the maintenance margin for yen-denominated futures can be met with assets denominated in, for example, USD. Only the variation margin needs to be met in JPY.

³ Typically, when USDJPY goes up, Japanese yen weakens. When USDJPY goes down, Japanese yen strengthens. Some market participants would interpret this pattern as an artifact of the “yen Carry Trade”, in which investors borrow Japanese yen to finance investments in risky assets. In a risk off mode, risky assets sell off and the yen loans are repaid – necessitating a bid on JPY (and thus USDJPY falls).

https://www.cmegroup.com/education/files/nikkei-correlation-trades.pdf
https://www.cmegroup.com/trading/equity-index/nikkei-225-futures-and-options.html