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Dynamic Models of Exchange Rate Dependence Using Option Prices and Historical Returns

  • Leonidas Tsiaras

    ()

    (Department of Business Studies, ASB, Aarhus University and CREATES)

Models 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 representation 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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Paper provided by School of Economics and Management, University of Aarhus in its series CREATES Research Papers with number 2010-35.

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Length: 43
Date of creation: 12 Jan 2010
Date of revision:
Handle: RePEc:aah:create:2010-35
Contact details of provider: Web page: http://www.econ.au.dk/afn/

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