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Is implied correlation worth calculating? Evidence from foreign exchange options and historical data


  • Christian Walter
  • Jose A. Lopez


Implied volatilities, as derived from option prices, have been shown to be useful in forecasting the subsequently observed volatility of the underlying financial variables. In this paper, we address the question of whether implied correlations, derived from options on the exchange rates in a currency trio, are useful in forecasting the observed correlations. We compare the forecast performance of the implied correlations from two currency trios with markedly different characteristics against correlation forecasts based on historical, time-series data. For the correlations in the USD/DEM/JPY currency trio, we find that implied correlations are useful in forecasting observed correlations, but they do not fully incorporate all the information in the historical data. For the correlations in the USD/DEM/CHF currency trio, implied correlations are much less useful. In general, since the performance of implied correlations varies across currency trios, implied correlations may not be worth calculating in all instances.

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  • Christian Walter & Jose A. Lopez, 2000. "Is implied correlation worth calculating? Evidence from foreign exchange options and historical data," Working Paper Series 2000-02, Federal Reserve Bank of San Francisco.
  • Handle: RePEc:fip:fedfwp:2000-02

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    Cited by:

    1. Michael S. Gibson & Brian H. Boyer, 1997. "Evaluating forecasts of correlation using option pricing," International Finance Discussion Papers 600, Board of Governors of the Federal Reserve System (U.S.).
    2. Christodoulakis, George A., 2007. "Common volatility and correlation clustering in asset returns," European Journal of Operational Research, Elsevier, vol. 182(3), pages 1263-1284, November.
    3. Demirer, Riza, 2013. "Can advanced markets help diversify risks in frontier stock markets? Evidence from Gulf Arab stock markets," Research in International Business and Finance, Elsevier, vol. 29(C), pages 77-98.
    4. Hui, Cho-Hoi & Lo, Chi-Fai & Lau, Chun-Sing, 2013. "Option-implied correlation between iTraxx Europe Financials and Non-Financials Indexes: A measure of spillover effect in European debt crisis," Journal of Banking & Finance, Elsevier, vol. 37(9), pages 3694-3703.
    5. Nikkinen, Jussi & Vähämaa, Sami, 2009. "Central bank interventions and implied exchange rate correlations," Journal of Empirical Finance, Elsevier, vol. 16(5), pages 862-873, December.
    6. Markopoulou, Chryssa & Skintzi, Vasiliki & Refenes, Apostolos, 2016. "On the predictability of model-free implied correlation," International Journal of Forecasting, Elsevier, vol. 32(2), pages 527-547.
    7. Mark T. Leung & An-Sing Chen, 2005. "Performance evaluation of neural network architectures: the case of predicting foreign exchange correlations," Journal of Forecasting, John Wiley & Sons, Ltd., vol. 24(6), pages 403-420.

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