July 6 (Bloomberg) -- Investors should bet option volatility on the dollar-yen exchange rate will fall as the U.S. currency rallies at a slower pace, Standard Chartered Plc said.

Demand for the dollar should drop as U.S. interest rates decline, reducing the currency's allure, the bank said in a research note. Standard Chartered economists expect the Federal Reserve to decrease the benchmark lending rate by 0.25 percentage point to 5 percent and the Bank of Japan to lift its key rate by 0.25 percent to 0.75 percent by year-end.

``We don't think the rally in the dollar will continue with the same speed'' because U.S. rates will stabilize, David Mann, a currency strategist at Standard Chartered in Hong Kong, said in a telephone interview. ``We expect implied volatility to decline.''

The dollar has appreciated about 7 percent versus the yen from this year's low of 115.15 yen on March 5. It rallied to the strongest in almost four years at 124.13 yen on June 22, and traded at 123.29 as of 8:06 a.m. in New York.

Standard Chartered forecasts the dollar will rise to 126 yen by the end of September and fall to 122 yen by year-end.

Options Strategy

The London-based bank, which earns two-thirds of its profits from Asia, recommends investors use an option strategy that will benefit from the combination of falling volatility and dollar appreciation. So-called implied volatility on dollar-yen options rebounded about 2 percentage points last month from record lows after surging Treasury yields lifted the dollar.

Volatility on three-month options on the dollar-yen rate was 6.7 percent today, about 2.2 percentage points above historical, or actual, volatility. The difference, or spread, was as wide as 2.61 percent this week, the greatest premium on implied volatility over actual since February 2004. Historical volatility measures a currency's actual movements.

Implied volatility, a gauge of traders' expectations for price swings, increases as demand for options rises. Traders quote implied volatility as part of pricing options.

``The spread between implied volatility and historic has widened during the recent dollar-yen rally,'' Mann said. ``We expect the spread to narrow over the next few months as implied volatility declines,'' given the likely slowdown in the pace of dollar gains.

Premium Wiped Out

Implied volatility on three-month options rose as high as 7.65 percent last week, up from 6 percent on June 5, the lowest since Bloomberg began tracking such data in December 1995.

Volatility on options increased in recent weeks as investors boosted purchases of put options, which protect against a dollar fall.

In February 2004, the last time the premium on implied volatility was so large, the dollar-yen rate had tumbled 14 percent over the preceding eight months. The implied versus historical volatility premium was wiped out by May 2004.

The yen is the worst-performing currency against the dollar among the world's 16 most-traded currencies this year, down 3.1 percent. The yen has suffered as investors sold it as part of the so-called carry trade, a strategy of borrowing at lower rates available in Japan and investing in countries where rates are higher.

Standard Chartered recommended that clients buy a three- month dollar call at a so-called strike price of 123.50 yen per dollar and simultaneously sell a three-month dollar put with a strike price of 117.50 yen.

Profiting From Puts

``This trade will benefit from a decline in implied volatility and a rise in the dollar versus the yen,'' Mann said. ``We like selling the put as it takes advantage of the fact that puts are relatively more expensive, netting a greater premium on the sale. Selling the option makes the trade cheaper.''

The premium on dollar puts, which grant the right to sell the currency, relative to calls, which give the right to buy, rose to the highest this week since April. The so-called three- month risk-reversal rate touched minus 1.8 percent this week. A minus value shows greater demand for puts versus calls.

Demand for dollar puts has risen amid ``investor concern that there might be an increase in rhetoric by officials in Japan to support the yen,'' Mann said.

The sale of the dollar put adds risk to the trade because if the exchange rate moves below 117.50 yen the purchaser might choose to exercise the option, triggering losses to the option seller.

``We are willing to take on this extra risk because we don't expect a rapid appreciation of the yen to the 117.50 per dollar in the next three months,'' Mann said. ``We don't expect appreciation of the yen to come until interest rates in Japan begin moving higher'' in the fourth quarter.

The trade, which cost 0.05 percent of the notional value, will produce profits if the dollar appreciates beyond 124.10. Losses, triggered by a weakening of the dollar, are unlimited.

To contact the reporter on this story: Liz McCormick in New York at emccormick7@bloomberg.net.

Last Updated: July 6, 2007 08:23 EDT