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How important is the term structure in implied volatility surface modeling? Evidence from foreign exchange options

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  • Chalamandaris, Georgios
  • Tsekrekos, Andrianos E.

Abstract

We claim that previously proposed parametric specifications that linearly approximate the term structure of the implied volatility surface (IVS) in option prices fail to capture important information regarding the expectations of market participants. This paper proposes a parametric specification for describing the IVS that allows flexible modeling of the term structure through a Nelson and Siegel (1987) factorization, recently proposed by Diebold and Li (2006) in the context of yield curve modeling. The specification is tested on implied volatilities from the over-the-counter foreign exchange options market, where contracts with long expiries are actively traded and thus the term structure dimension of the surface should be very important. We first show that the proposed volatility specification can consistently and remarkably improve our ability to describe the surface on any given day. We then establish the economic relevance of the incremental information captured by our proposed specification by showing that it can produce more accurate forecasts of implied volatility that can support long-term profitable trading strategies in the absence of transaction costs.

Suggested Citation

  • Chalamandaris, Georgios & Tsekrekos, Andrianos E., 2011. "How important is the term structure in implied volatility surface modeling? Evidence from foreign exchange options," Journal of International Money and Finance, Elsevier, vol. 30(4), pages 623-640, June.
  • Handle: RePEc:eee:jimfin:v:30:y:2011:i:4:p:623-640
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    Cited by:

    1. Guo, Biao & Han, Qian & Lin, Hai, 2015. "Forecasting the Term Structure of Implied Volatilities," Working Paper Series 6189, Victoria University of Wellington, School of Economics and Finance.
    2. repec:eee:riibaf:v:41:y:2017:i:c:p:445-460 is not listed on IDEAS

    More about this item

    Keywords

    C53 G13 F37 Exchange rates Term structure Implied volatility surfaces Volatility functions Forecasting Foreign exchange options;

    JEL classification:

    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • F37 - International Economics - - International Finance - - - International Finance Forecasting and Simulation: Models and Applications

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