TY - JOUR

T1 - Does implied volatility of currency futures option imply volatility of exchange rates?

AU - Wang, Tse-Shih

PY - 2007/2/1

Y1 - 2007/2/1

N2 - 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.

AB - 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.

UR - http://www.scopus.com/inward/record.url?scp=33751091530&partnerID=8YFLogxK

UR - http://www.scopus.com/inward/citedby.url?scp=33751091530&partnerID=8YFLogxK

U2 - 10.1016/j.physa.2006.08.040

DO - 10.1016/j.physa.2006.08.040

M3 - Article

AN - SCOPUS:33751091530

VL - 374

SP - 773

EP - 782

JO - Physica A: Statistical Mechanics and its Applications

JF - Physica A: Statistical Mechanics and its Applications

SN - 0378-4371

IS - 2

ER -