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Predictable dynamics in implied volatility surfaces from OTC currency options

Research output: Contribution to journalJournal article

Published

Journal publication date06/2010
JournalJournal of Banking and Finance
Journal number6
Volume34
Number of pages14
Pages1175-1188
Original languageEnglish

Abstract

Recent empirical studies report predictable dynamics in the volatility surfaces that are implied by observed index option prices, such as those prescribed by general equilibrium models. Using an extensive data set from the over-the-counter options market, we document similar predictability in the factors that capture the daily variation of surfaces implied by options on 25 different foreign exchange rates. We proceed to demonstrate that simple vector autoregressive specifications for the factors can help produce accurate out-of-sample forecasts of the systematic component of the surface at short horizons. Profitable delta-hedged positions can be set up based on these forecasts; however, profits disappear when typical transaction costs are taken into account and when trading rules on wide segments of the surface are sought.