Modeling moneyness volatility in measuring exchange rate volatility

The implied volatility (IV) is widely believed to be the best measure of exchange rate volatility. Despite its widespread usage, the IV approach suffers from an obvious chicken-egg problem: obtaining an unbiased IV requires the options to be priced correctly and calculating option prices accurately...

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Bibliographic Details
Main Authors: Hoque, A., Krishnamurti, C.
Format: Conference Proceeding
Language:English
Subjects:
Asynchronous transfer mode
Design automation
Diebold-Mariano test
Equations
Exchange rates
Forecasting
Granger-Newbold test
Implied volatility
Mathematical model
moneyness volatility
Pricing
realized volatility
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Summary:The implied volatility (IV) is widely believed to be the best measure of exchange rate volatility. Despite its widespread usage, the IV approach suffers from an obvious chicken-egg problem: obtaining an unbiased IV requires the options to be priced correctly and calculating option prices accurately requires an unbiased IV. We contribute to this literature by developing a new model for exchange rate volatility which we term as the "moneyness volatility (MV)". Besides eliminating the chicken-egg problem of IV, the MV approach outperforms the IV in forecasting ability in both in-sample and out-of-sample tests. The F-test, Granger-Newbold test and Diebold-Mariano test results consistently reveal that MV outperforms IV in estimating as well as forecasting exchange rate volatility. Furthermore, test results reveal that our approach works well for the six major currency options. Our pioneering approach in modeling exchange rate volatility has far-reaching implications for academicians, professional traders and risk managers.
ISSN:2380-8454
DOI:10.1109/CIFER.2011.5953555