Dec 2 (Reuters) - The FX option volatility risk premium for the Dec. 19 Bank of Japan policy announcement is increasing and should warn JPY traders to expect a significant FX reaction to the decision.

Volatility is a key yet unknown parameter of an FX option premium, so dealers use implied volatility as a substitute. Any disparity between implied and actual/realised volatility makes it a tradable asset.

Benchmark 1-month implied volatility highlighted the Bank of Japan event risk premium when its expiry first included the outcome from Nov. 19, increasing from 10.35 to 11.3. There has been more demand and premium for post-BoJ expiry implied volatility as the uncertainty increases amid growing expectations of a rate hike, which has already boosted JPY strength.

Short-duration options, like overnight expiries, provide an early indication of market sentiment over key events. While current overnight options don't yet cover the BoJ meeting, forward-looking volatility projections suggest USD/JPY implied volatility for overnight expiries could spike to around 32.0 once the BoJ decision is factored in - more than double typical daily levels.

In premium/break-even terms, 32.0 implied volatility is 201 JPY pips in either direction for a simple vanilla straddle option. That exceeds the prices seen for the Oct. 31 BoJ when implied volatility was 22.5 and on Sept. 20 when it reached 26.0, highlighting the market's heightened expectations for the upcoming decision.

For more click on

<^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ 1-month expiry USD/JPY implied volatility

^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^>

(Richard Pace is a Reuters market analyst. The views expressed are his own)

((Richard.Pace@thomsonreuters.com))