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Are Option-Implied Forecasts of Exchange Rate Volatility Excessively Variable?

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  • Shang-Jin Wei
  • Jeffrey A. Frankel

Abstract

Market participants' forecasts of future exchange rate volatility can be recovered from option contracts on foreign currencies. Such implicit volatility forecasts for four currencies are used to test rational expectations jointly with the applicability of the standard Black-Scholes formula. First, we examine the null hypothesis that the market-anticipated one-month-ahead standard deviation is an unbiased estimator of the subsequent realized standard deviation. The parametric regression method rejects this hypothesis overwhelmingly: the implicit forecasts are themselves excessively variable. Simulations indicate that the rejection is not caused by non-normality of the error term. Second, we use a nonparametric method to test a weaker version of market rationality: the market can correctly forecast the direction of the change in exchange rate volatility. This time, the weaker version of rationality is confirmed- Third, we investigate how market forecasts are formed. We find some evidence that market participants put heavy weight on lagged volatility when forecasting future volatility. Finally, results from the Alternating Conditional Expectations algorithm provide further support for the central finding that when the market predicts a large deviation of volatility from its mean, it could do better by moderating its forecast.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 3910.

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Date of creation: Nov 1991
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Handle: RePEc:nbr:nberwo:3910

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  1. Hsieh, David A., 1984. "Tests of rational expectations and no risk premium in forward exchange markets," Journal of International Economics, Elsevier, Elsevier, vol. 17(1-2), pages 173-184, August.
  2. Adams, Paul D. & Wyatt, Steve B., 1989. "On the pricing of European and American foreign currency options: a clarification," Journal of International Money and Finance, Elsevier, Elsevier, vol. 8(2), pages 305-311, June.
  3. Robert C. Merton, 1973. "Theory of Rational Option Pricing," Bell Journal of Economics, The RAND Corporation, The RAND Corporation, vol. 4(1), pages 141-183, Spring.
  4. Buttler, Hans-Jurg, 1989. "An expository note on the valuation of foreign exchange options," Journal of International Money and Finance, Elsevier, Elsevier, vol. 8(2), pages 295-304, June.
  5. Lai, Kon S., 1990. "An evaluation of survey exchange rate forecasts," Economics Letters, Elsevier, Elsevier, vol. 32(1), pages 61-65, January.
  6. Ralph Tryon, 1979. "Testing for rational expectations in foreign exchange markets," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 139, Board of Governors of the Federal Reserve System (U.S.).
  7. Shang-Jin Wei, 1991. "Anticipations of foreign exchange volatility and bid-ask spreads," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 409, Board of Governors of the Federal Reserve System (U.S.).
  8. Henriksson, Roy D & Merton, Robert C, 1981. "On Market Timing and Investment Performance. II. Statistical Procedures for Evaluating Forecasting Skills," The Journal of Business, University of Chicago Press, University of Chicago Press, vol. 54(4), pages 513-33, October.
  9. Frankel, Jeff & Froot, Ken, 1986. "Using Survey Data to Test Standard Propositions Regarding Exchange Rate Expectations," Department of Economics, Working Paper Series, Department of Economics, Institute for Business and Economic Research, UC Berkeley qt1972q8wm, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
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  14. Richard Meese & Kenneth Rogoff, 1983. "The Out-of-Sample Failure of Empirical Exchange Rate Models: Sampling Error or Misspecification?," NBER Chapters, in: Exchange Rates and International Macroeconomics, pages 67-112 National Bureau of Economic Research, Inc.
  15. Philippe Jorion, 1988. "On Jump Processes in the Foreign Exchange and Stock Markets," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 1(4), pages 427-445.
  16. Froot, Kenneth A & Frankel, Jeffrey A, 1989. "Forward Discount Bias: Is It an Exchange Risk Premium?," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 104(1), pages 139-61, February.
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  20. Ware, Roger & Winter, Ralph, 1988. "Forward markets, currency options and the hedging of foreign exchange risk," Journal of International Economics, Elsevier, Elsevier, vol. 25(3-4), pages 291-302, November.
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  22. Eduardo R. Borensztein & Michael P. Dooley, 1987. "Options on Foreign Exchange and Exchange Rate Expectations," IMF Staff Papers, Palgrave Macmillan, vol. 34(4), pages 643-680, December.
  23. Havenner, Arthur & Modjtahedi, Bagher, 1988. "Foreign exchange rates : A multiple currency and maturity analysis," Journal of Econometrics, Elsevier, Elsevier, vol. 37(2), pages 251-264, February.
  24. Merton, Robert C., 1977. "On the pricing of contingent claims and the Modigliani-Miller theorem," Journal of Financial Economics, Elsevier, Elsevier, vol. 5(2), pages 241-249, November.
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Citations

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Cited by:
  1. Bronka Rzepkowski, 2001. "Pouvoir prédictif de la volatilité implicite dans le prix des options de change," Économie et Prévision, Programme National Persée, Programme National Persée, vol. 148(2), pages 71-97.
  2. Alexander Mende, 2006. "09/11 on the USD/EUR foreign exchange market," Applied Financial Economics, Taylor & Francis Journals, Taylor & Francis Journals, vol. 16(3), pages 213-222.
  3. Kroner, Kenneth F. & Kneafsey, Devin P. & Claessens, Stijn & DEC, 1993. "Forecasting volatility in commodity markets," Policy Research Working Paper Series 1226, The World Bank.

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