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Forecasting foreign exchange volatility: why is implied volatility biased and inefficient? and does it matter?

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  • Christopher J. Neely

Abstract

Research has consistently found that implied volatility is a conditionally biased predictor of realized volatility across asset markets. This paper evaluates explanations for this bias in the market for options on foreign exchange futures. No solution considered—including a model of priced volatility risk—explains the conditional bias found in implied volatility. Further, while implied volatility fails to subsume econometric forecasts in encompassing regressions, these forecasts do not significantly improve delta-hedging performance. Thus this paper deepens the implied volatility puzzle by rejecting popular explanations for forecast bias while demonstrating that statistical measures of bias and informational inefficiency should be treated with circumspection.

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Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2002-017.

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Date of creation: 2004
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Handle: RePEc:fip:fedlwp:2002-017

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Keywords: Forecasting ; Foreign exchange rates;

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Cited by:
  1. Agnolucci, Paolo, 2009. "Volatility in crude oil futures: A comparison of the predictive ability of GARCH and implied volatility models," Energy Economics, Elsevier, Elsevier, vol. 31(2), pages 316-321, March.
  2. Ariful Hoque & Chandrasekhar Krishnamurti, 2012. "Modeling moneyness volatility in measuring exchange rate volatility," International Journal of Managerial Finance, Emerald Group Publishing, Emerald Group Publishing, vol. 8(4), pages 365-380.
  3. Hui Guo & Christopher J. Neely & Jason Higbee, 2006. "Foreign exchange volatility is priced in equities," Working Papers, Federal Reserve Bank of St. Louis 2004-029, Federal Reserve Bank of St. Louis.
  4. Kellard, Neil & Dunis, Christian & Sarantis, Nicholas, 2010. "Foreign exchange, fractional cointegration and the implied-realized volatility relation," Journal of Banking & Finance, Elsevier, vol. 34(4), pages 882-891, April.
  5. Christoffersen, Peter & Mazzotta, Stefano, 2004. "The informational content of over-the-counter currency options," Working Paper Series, European Central Bank 0366, European Central Bank.
  6. Tim Bollerslev & Hao Zhou, 2003. "Volatility puzzles: a unified framework for gauging return-volatility regressions," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 2003-40, Board of Governors of the Federal Reserve System (U.S.).
  7. Joseph K. W. Fung & Ted Z. X. Zeng, 2012. "Are Derivative Warrants Overpriced?," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 32(12), pages 1144-1170, December.

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