TY - JOUR

T1 - How important is the term structure in implied volatility modelling

T2 - evidence from foreign exchange options

AU - Chalamandaris, Georgios

AU - Tsekrekos, Andrianos

PY - 2011/6

Y1 - 2011/6

N2 - 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.

AB - 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.

KW - exchange rates

KW - term structure

KW - implied volatility surfaces

KW - volatility functions

KW - forecasting

KW - foreign exchange options

U2 - 10.1016/j.jimonfin.2011.02.001

DO - 10.1016/j.jimonfin.2011.02.001

M3 - Journal article

VL - 30

SP - 623

EP - 640

JO - Journal of International Money and Finance

JF - Journal of International Money and Finance

SN - 0261-5606

IS - 4

ER -