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Spot and forward volatility in foreign exchange

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  • Della Corte, Pasquale
  • Sarno, Lucio
  • Tsiakas, Ilias

Abstract

This paper investigates the empirical relation between spot and forward implied volatility in foreign exchange. We formulate and test the forward volatility unbiasedness hypothesis, which may be viewed as the volatility analogue to the extensively researched hypothesis of unbiasedness in forward exchange rates. Using a new dataset of spot implied volatility quoted on over-the-counter currency options, we compute the forward implied volatility that corresponds to the delivery price of a forward contract on future spot implied volatility. This contract is known as a forward volatility agreement. We find strong evidence that forward implied volatility is a systematically biased predictor that overestimates movements in future spot implied volatility. This bias in forward volatility generates high economic value to an investor exploiting predictability in the returns to volatility speculation and indicates the presence of predictable volatility term premiums in foreign exchange.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Financial Economics.

Volume (Year): 100 (2011)
Issue (Month): 3 (June)
Pages: 496-513

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Handle: RePEc:eee:jfinec:v:100:y:2011:i:3:p:496-513

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Web page: http://www.elsevier.com/locate/inca/505576

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Keywords: Implied volatility Foreign exchange Forward volatility agreement Unbiasedness Volatility speculation;

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References

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Citations

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Cited by:
  1. Lucio Sarno & Paul Schneider & Christian Wagner, 2012. "Properties of Foreign Exchange Risk Premiums," Working Paper Series 10_12, The Rimini Centre for Economic Analysis.
  2. Philippe Mueller & Andreas Stathopoulos & Andrea Vedolin, . "International Correlation Risk," FMG Discussion Papers dp716, Financial Markets Group.
  3. Theophilos Papadimitriou & Periklis Gogas & Vasilios Plakandaras, 2013. "Forecasting the NOK/USD Exchange Rate with Machine Learning Techniques," Working Paper Series 59_13, The Rimini Centre for Economic Analysis.
  4. Marco J. Lombardi & Francesco Ravazzolo, 2012. "Oil price density forecasts: exploring the linkages with stock markets," Working Paper 2012/24, Norges Bank.
  5. Huang, Huichou & MacDonald, Ronald & Zhao, Yang, 2012. "Global Currency Misalignments, Crash Sensitivity, and Downside Insurance Costs," MPRA Paper 53745, University Library of Munich, Germany, revised 18 Nov 2013.
  6. Juan M. Londono & Hao Zhou, 2012. "Variance risk premiums and the forward premium puzzle," International Finance Discussion Papers 1068, Board of Governors of the Federal Reserve System (U.S.).
  7. Cenedese, Gino & Sarno, Lucio & Tsiakas, Ilias, 2014. "Foreign exchange risk and the predictability of carry trade returns," Journal of Banking & Finance, Elsevier, vol. 42(C), pages 302-313.
  8. Carol Osler, 2012. "Market Microstructure and the Profitability of Currency Trading," Working Papers 48, Brandeis University, Department of Economics and International Businesss School.
  9. Marco Jacopo Lombardi, 2013. "On the correlation between commodity and equity returns: implications for portfolio allocation," BIS Working Papers 420, Bank for International Settlements.
  10. Jiahan Li & Ilias Tsiakas & Wei Wang, 2014. "Predicting Exchange Rates Out of Sample: Can Economic Fundamentals Beat the Random Walk?," Working Paper Series 05_14, The Rimini Centre for Economic Analysis.

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