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Is implied correlation worth calculating? Evidence from foreign exchange options and historical data

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  • Christian Walter
  • Jose A. Lopez

Abstract

Implied volatilities, as derived from option prices, have been shown to be useful in forecasting the subsequently observed volatility of the underlying financial variables. In this paper, we address the question of whether implied correlations, derived from options on the exchange rates in a currency trio, are useful in forecasting the observed correlations. We compare the forecast performance of the implied correlations from two currency trios with markedly different characteristics against correlation forecasts based on historical, time-series data. For the correlations in the USD/DEM/JPY currency trio, we find that implied correlations are useful in forecasting observed correlations, but they do not fully incorporate all the information in the historical data. For the correlations in the USD/DEM/CHF currency trio, implied correlations are much less useful. In general, since the performance of implied correlations varies across currency trios, implied correlations may not be worth calculating in all instances.

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Bibliographic Info

Paper provided by Federal Reserve Bank of San Francisco in its series Working Paper Series with number 2000-02.

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Date of creation: 2000
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Handle: RePEc:fip:fedfwp:2000-02

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Keywords: Options (Finance) ; Foreign exchange;

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Cited by:
  1. Hui, Cho-Hoi & Lo, Chi-Fai & Lau, Chun-Sing, 2013. "Option-implied correlation between iTraxx Europe Financials and Non-Financials Indexes: A measure of spillover effect in European debt crisis," Journal of Banking & Finance, Elsevier, vol. 37(9), pages 3694-3703.
  2. Demirer, Riza, 2013. "Can advanced markets help diversify risks in frontier stock markets? Evidence from Gulf Arab stock markets," Research in International Business and Finance, Elsevier, vol. 29(C), pages 77-98.
  3. Michael S. Gibson & Brian H. Boyer, 1997. "Evaluating forecasts of correlation using option pricing," International Finance Discussion Papers 600, Board of Governors of the Federal Reserve System (U.S.).

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