Does implied volatility of currency futures option imply volatility of exchange rates?

Research output: Contribution to journalArticle

3 Citations (Scopus)

Abstract

By investigating currency futures options, this paper provides an alternative economic implication for the result reported by Stein [Overreactions in the options market, Journal of Finance 44 (1989) 1011-1023] that long-maturity options tend to overreact to changes in the implied volatility of short-maturity options. When a GARCH process is assumed for exchange rates, a continuous-time relationship is developed. We provide evidence that implied volatilities may not be the simple average of future expected volatilities. By comparing the term-structure relationship of implied volatilities with the process of the underlying exchange rates, we find that long-maturity options are more consistent with the exchange rates process. In sum, short-maturity options overreact to the dynamics of underlying assets rather than long-maturity options overreacting to short-maturity options.

Original languageEnglish
Pages (from-to)773-782
Number of pages10
JournalPhysica A: Statistical Mechanics and its Applications
Volume374
Issue number2
DOIs
Publication statusPublished - 2007 Feb 1

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Implied Volatility
Currency
volatility
Exchange rate
Volatility
Imply
finance
Term Structure
Generalized Autoregressive Conditional Heteroscedasticity
Finance
economics
Continuous Time
Economics
Tend
Alternatives

All Science Journal Classification (ASJC) codes

  • Statistics and Probability
  • Condensed Matter Physics

Cite this

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title = "Does implied volatility of currency futures option imply volatility of exchange rates?",
abstract = "By investigating currency futures options, this paper provides an alternative economic implication for the result reported by Stein [Overreactions in the options market, Journal of Finance 44 (1989) 1011-1023] that long-maturity options tend to overreact to changes in the implied volatility of short-maturity options. When a GARCH process is assumed for exchange rates, a continuous-time relationship is developed. We provide evidence that implied volatilities may not be the simple average of future expected volatilities. By comparing the term-structure relationship of implied volatilities with the process of the underlying exchange rates, we find that long-maturity options are more consistent with the exchange rates process. In sum, short-maturity options overreact to the dynamics of underlying assets rather than long-maturity options overreacting to short-maturity options.",
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Does implied volatility of currency futures option imply volatility of exchange rates? / Wang, Tse-Shih.

In: Physica A: Statistical Mechanics and its Applications, Vol. 374, No. 2, 01.02.2007, p. 773-782.

Research output: Contribution to journalArticle

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