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Foreign exchange option and returns based correlation forecasts: evaluation and two applications

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  • Castrén, Olli
  • Mazzotta, Stefano

Abstract

We compare option-implied correlation forecasts from a dataset consisting of over 10 years of daily data on over-the-counter (OTC) currency option prices to a set of return-based correlation measures and assess the relative quality of the correlation forecasts. We find that while the predictive power of implied correlation is not always superior to that of returns based correlations measures, it tends to provide the most consistent results across currencies. Predictions that use both implied and returns-based correlations generate the highest adjusted R2s, explaining up to 42 per cent of the realised correlations. We then apply the correlation forecasts to two policyrelevant topics, to produce scenario analyses for the euro effective exchange rate index, and to analyse the impact on cross-currency co-movement of interventions on the JPY/USD exchange rate. JEL Classification: F31, F37, G15

Suggested Citation

  • Castrén, Olli & Mazzotta, Stefano, 2005. "Foreign exchange option and returns based correlation forecasts: evaluation and two applications," Working Paper Series 447, European Central Bank.
    • Handle: RePEc:ecb:ecbwps:2005447
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    1. Tomas Adam & Robert Ambrisko & Oxana Babecka Kucharcukova & Jan Babecky & Sona Benecka & Jan Bruha & Vilma Dingova & Dana Hajkova & Tomas Holub & Eva Hromadkova & David Kocourek & Lubos Komarek & Zlat, 2014. "Analyses of the Czech Republic's Current Economic Alignment with the Euro Area 2014," Occasional Publications - Edited Volumes, Czech National Bank, number as14 edited by Kamila Kulhava & Jakub Mateju, January.
    2. Daniel Stavárek, 2009. "Assessment of the exchange rate convergence in Euro-candidate countries," The AMFITEATRU ECONOMIC journal, Academy of Economic Studies - Bucharest, Romania, vol. 11(25), pages 159-180, February.
    3. Hassan, M. Kabir & Ngene, Geoffrey M. & Yu, Jung-Suk, 2015. "Credit default swaps and sovereign debt markets," Economic Systems, Elsevier, vol. 39(2), pages 240-252.
    4. Katerina Arnostova & Oxana Babecka Kucharcukova & Jan Babecky & Vojtech Belling & Sona Benecka & Jan Bruha & Martin Gurtler & Tomas Holub & Eva Hromadkova & Lubos Komarek & Zlatuse Komarkova & Petr Kr, 2016. "Analyses of the Czech Republic's Current Economic Alignment with the Euro Area 2016," Occasional Publications - Edited Volumes, Czech National Bank, number as16 edited by Katerina Arnostova & Lucie Matejkova, January.
    5. Tomas Adam & Oxana Babecka Kucharcukova & Jan Babecky & Vojtech Belling & Sona Benecka & Jan Bruha & Kamil Galuscak & Tomas Holub & Eva Hromadkova & Lubos Komarek & Zlatuse Komarkova & Kamila Kulhava , 2015. "Analyses of the Czech Republic's Current Economic Alignment with the Euro Area 2015," Occasional Publications - Edited Volumes, Czech National Bank, number as15 edited by Kamila Kulhava & Lucie Matejkova, January.
    6. Leonidas Tsiaras, 2010. "Dynamic Models of Exchange Rate Dependence Using Option Prices and Historical Returns," CREATES Research Papers 2010-35, Department of Economics and Business Economics, Aarhus University.
    7. Katerina Arnostova & Tomas Adam & Oxana Babecka Kucharcukova & Jan Babecky & Vojtech Belling & Sona Benecka & Jan Bruha & Martin Gurtler & Tibor Hledik & Tomas Holub & Eva Hromadkova & Lubos Komarek &, 2017. "Analyses of the Czech Republic's Current Economic Alignment with the Euro Area 2017," Occasional Publications - Edited Volumes, Czech National Bank, number as17 edited by Katerina Arnostova & Lucie Matejkova, January.
    8. Bisht Deepak & Laha, A. K., 2017. "Assessment of Density Forecast for Energy Commodities in Post-Financialization Era," IIMA Working Papers WP 2017-07-01, Indian Institute of Management Ahmedabad, Research and Publication Department.
    9. Robert Ambrisko & Katerina Arnostova & Oxana Babecka Kucharcukova & Jan Babecky & Jan Bruha & Kamil Galuscak & Adam Gersl & Dana Hajkova & Tomas Holub & Narcisa Liliana Kadlcakova & Lubos Komarek & Zl, 2010. "Analyses of the Czech Republic's Current Economic Alignment with the Euro Area 2010," Occasional Publications - Edited Volumes, Czech National Bank, number as10 edited by Dana Hajkova & Romana Zamazalova, January.
    10. Tomas Adam & Oxana Babecka Kucharcukova & Jan Babecky & Jan Bruha & Tomas Holub & Eva Hromadkova & David Kocourek & Lubos Komarek & Zlatuse Komarkova & Kamila Kulhava & Petr Kral & Ivana Kubicova & Ji, 2013. "Analyses of the Czech Republic's Current Economic Alignment with the Euro Area 2013," Occasional Publications - Edited Volumes, Czech National Bank, number as13 edited by Jakub Mateju & Kamila Kulhava, January.
    11. Kopaliani, R. & Denisov, N., 2023. "Composite option pricing and the volatility surface construction," Journal of the New Economic Association, New Economic Association, vol. 60(3), pages 27-48.
    12. Tomas Adam & Oxana Babecka Kucharcukova & Jan Babecky & Kamil Galuscak & Tomas Holub & Eva Hromadkova & Narcisa Liliana Kadlcakova & Lubos Komarek & Zlatuse Komarkova & Petr Kral & Ivana Kubicova & Ji, 2012. "Analyses of the Czech Republic's Current Economic Alignment with the Euro Area 2012," Occasional Publications - Edited Volumes, Czech National Bank, number as12 edited by Romana Zamazalova & Jakub Mateju, January.

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    More about this item

    Keywords

    Correlation forecasts; currency options data; effective exchange rate;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F37 - International Economics - - International Finance - - - International Finance Forecasting and Simulation: Models and Applications
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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