How important is the term structure in implied volatility surface modeling? Evidence from foreign exchange options
AbstractWe claim that previously proposed parametric specifications that linearly approximate the term structure of the implied volatility surface (IVS) in option prices fail to capture important information regarding the expectations of market participants. This paper proposes a parametric specification for describing the IVS that allows flexible modeling of the term structure through a Nelson and Siegel (1987) factorization, recently proposed by Diebold and Li (2006) in the context of yield curve modeling. The specification is tested on implied volatilities from the over-the-counter foreign exchange options market, where contracts with long expiries are actively traded and thus the term structure dimension of the surface should be very important. We first show that the proposed volatility specification can consistently and remarkably improve our ability to describe the surface on any given day. We then establish the economic relevance of the incremental information captured by our proposed specification by showing that it can produce more accurate forecasts of implied volatility that can support long-term profitable trading strategies in the absence of transaction costs.
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Bibliographic InfoArticle provided by Elsevier in its journal Journal of International Money and Finance.
Volume (Year): 30 (2011)
Issue (Month): 4 (June)
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Web page: http://www.elsevier.com/locate/inca/30443
C53 G13 F37 Exchange rates Term structure Implied volatility surfaces Volatility functions Forecasting Foreign exchange options;
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- C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
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