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The Forecast Ability of Option-implied Densities from Emerging Markets Currencies

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  • Ornelas, José Renato Haas

Abstract

This paper empirically evaluates Risk-Neutral Densities (RND) and Real-World Densities (RWD) as predictors of emerging markets currencies. The dataset consists of volatility surfaces from 11 emerging market currencies, with approximately six years of daily data, using options with one-month expiration. Therefore, there is a strong overlapping in data, which is tackled with specific econometric techniques. Results of the out-of-sample assessment show that both RND and RWD underweight the tails of the actual distribution. This is probably due to the lack of options with extreme strikes. Although the RWDs perform better than RND in terms of Kolmogorov distance, they still have problems in fitting the tails of actual data. Thus, the risk-aversion adjustment may improve the forecast ability, but it does not solve the tails misfitting.

Suggested Citation

  • Ornelas, José Renato Haas, 2016. "The Forecast Ability of Option-implied Densities from Emerging Markets Currencies," Brazilian Review of Econometrics, Sociedade Brasileira de Econometria - SBE, vol. 36(1), March.
    • Handle: RePEc:sbe:breart:v:36:y:2016:i:1:a:45406
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    Cited by:

    1. José Valentim Machado Vicente & Jaqueline Terra Moura Marins, 2019. "A Volatility Smile-Based Uncertainty Index," Working Papers Series 502, Central Bank of Brazil, Research Department.
    2. Haas Ornelas, José Renato, 2019. "Expected currency returns and volatility risk premia," The North American Journal of Economics and Finance, Elsevier, vol. 49(C), pages 206-234.
    3. Jaqueline Terra Moura Marins, 2020. "Option-Based Risk Aversion Indicators for Predicting Currency Crises in Emerging Markets," Working Papers Series 515, Central Bank of Brazil, Research Department.
    4. Jaqueline Terra Moura Marins, 2024. "Predictability of Exchange Rate Density Forecasts for Emerging Economies in the Short Run," Working Papers Series 588, Central Bank of Brazil, Research Department.

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