Implied volatilities, stochastic interest rates, and currency futures options valuation: an empirical investigation

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Implied volatilities, stochastic interest rates, and currency futures options valuation: an empirical investigation

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Vivek Bhargava, Robert Brooks, D.K. Malhotra

Abstract

Different models of pricing currency call and put options on futures are empirically tested. Option prices are determined using different models and compared to actual market prices. Option prices are determined using historical as well as implied volatility. The different models tested include both constant and stochastic interest rate models. To determine if the model prices are different from the market prices, regression analysis and paired t -tests are performed. To see which model misprices the least, root mean square errors are determined. It is found that better results are obtained when implied volatility is used. Stochastic interest rate models perform better than constant interest rate models.

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Article provided by Taylor and Francis Journals in its journal The European Journal of Finance.

Volume (Year): 7 (2001)
Issue (Month): 3 (September)
Pages: 231-246
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Handle: RePEc:taf:eurjfi:v:7:y:2001:i:3:p:231-246

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References listed on IDEAS
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Orlin J. Grabbe, . "The Pricing of Call and Put Options on Foreign Exchange," Rodney L. White Center for Financial Research Working Papers 06-83, Wharton School Rodney L. White Center for Financial Research.
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Angelo Melino & Stuart M. Turnbull, 1991. "The Pricing of Foreign Currency Options," Canadian Journal of Economics, Canadian Economics Association, vol. 24(2), pages 251-81, May. [Downloadable!] (restricted)
Hilliard, Jimmy E. & Madura, Jeff & Tucker, Alan L., 1991. "Currency Option Pricing with Stochastic Domestic and Foreign Interest Rates," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 26(02), pages 139-151, June. [Downloadable!]
Geske, Robert & Shastri, Kuldeep, 1985. "The early exercise of American puts," Journal of Banking & Finance, Elsevier, vol. 9(2), pages 207-219, June. [Downloadable!] (restricted)
Melino, Angelo & Turnbull, Stuart M., 1990. "Pricing foreign currency options with stochastic volatility," Journal of Econometrics, Elsevier, vol. 45(1-2), pages 239-265. [Downloadable!] (restricted)
Shastri, Kuldeep & Tandon, Kishore, 1986. "Valuation of Foreign Currency Options: Some Empirical Tests," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 21(02), pages 145-160, June. [Downloadable!]
Robert C. Merton, 1973. "Theory of Rational Option Pricing," Bell Journal of Economics, The RAND Corporation, vol. 4(1), pages 141-183, Spring. [Downloadable!] (restricted)
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Orlin J. Grabbe, . "The Pricing of Call and Put Options on Foreign Exchange," Rodney L. White Center for Financial Research Working Papers 6-83, Wharton School Rodney L. White Center for Financial Research.
Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June. [Downloadable!] (restricted)
Shastri, Kuldeep & Tandon, Kishore, 1987. "Valuation of American options on foreign currency," Journal of Banking & Finance, Elsevier, vol. 11(2), pages 245-269, June. [Downloadable!] (restricted)

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