Dynamic Models of Exchange Rate Dependence Using Option Prices and Historical Returns
AbstractModels for the conditional joint distribution of the U.S. Dollar/Japanese Yen and Euro/Japanese Yen exchange rates, from November 2001 until June 2007, are evaluated and compared. The conditional dependency is allowed to vary across time, as a function of either historical returns or a combination of past return data and option-implied dependence estimates. Using prices of currency options that are available in the public domain, risk-neutral dependency expectations are extracted through a copula repre- sentation of the bivariate risk-neutral density. For this purpose, we employ either the one-parameter \Normal" or a two-parameter \Gumbel Mixture" specification. The latter provides forward-looking information regarding the overall degree of covariation, as well as, the level and direction of asymmetric dependence. Specifications that include option-based measures in their information set are found to outperform, in-sample and out-of-sample, models that rely solely on historical returns.
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Bibliographic InfoPaper provided by School of Economics and Management, University of Aarhus in its series CREATES Research Papers with number 2010-35.
Date of creation: 12 Jan 2010
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Web page: http://www.econ.au.dk/afn/
Exchange Rates; Implied Correlation; Copula; Forecasting; Options;
Find related papers by JEL classification:
- F31 - International Economics - - International Finance - - - Foreign Exchange
- F37 - International Economics - - International Finance - - - International Finance Forecasting and Simulation: Models and Applications
- G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
- G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
- G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation
This paper has been announced in the following NEP Reports:
- NEP-ALL-2010-09-03 (All new papers)
- NEP-FOR-2010-09-03 (Forecasting)
- NEP-IFN-2010-09-03 (International Finance)
- NEP-MON-2010-09-03 (Monetary Economics)
- NEP-OPM-2010-09-03 (Open Economy Macroeconomic)
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