Cross Economic Determinants of Implied Volatility Smile Dynamics: Three Major European Currency Options

Abstract

This paper examines the contemporaneous and lead–lag relationships between economic variables and implied volatility smiles for three major European currency options. We find that cross economic determinants are at least as important as own economic variables in explaining the dynamics of implied volatility smiles. Out‐of‐sample tests also suggest that cross economic variables are important in predicting an economy's currency option smile. These findings suggest that the price impact from cross economic determinants may help fill the gap between the theoretical and the practical implied volatility skews.

The economic determinants of the implied volatility function for currency options

“…A rise in the level of uncertainty as reflected in higher volatility is expected to make option traders demand higher premia for out-of-the-money options which would in turn affect the curvature of the volatility smile. Momentum (FXMOM) in the exchange rate is defined as the natural log of the ratio of daily closing exchange rate to the 20-day simple moving average of the exchange rate. Thus F X M O M = .25em ln false( S t / 1 / 20 ∑ i = t − 19 t S i false) is used to capture the trend in the underlying market, following Pena et al (1999), Beber (2008) and Han et al (2015). A sustained upward or downward momentum in the exchange rate is expected to result in increased demand for either calls or puts, thus impacting the skewness of the smile. The jump (FXJMP) in the exchange rate is defined as the ratio of the overnight return of the current day to the intraday volatility of the previous day.…”

“…The intraday realized volatility is computed applying Parkinson’s (1980) formula to intraday high and low spot rates such that: A high (low) value for FXJMP would indicate a larger (smaller) overnight change in the exchange rate as compared to the previous day’s volatility. A jump in the exchange rate is expected to increase demand for either out-of-the-money calls or puts and thus affect the skewness of the smile. Default spread (SPRD) measured as the difference between the yields of the ten-year domestic government bond and the ten-year US Treasury Note is included as an economic determinant (Han et al , 2015). Any increase in the default spread reflects a higher probability of default, thus triggering outflow of capital from the domestic economy as foreign investors pull out their funds.…”

“…Foreign Institutional investors are influential in the Indian stock market and heavy selling by them is known to spark volatility in the stock market and consequently weaken the Indian rupee. The volatility spillover from the stock market may be expected to cause changes in the shape of the volatility smile of currency options (Han et al , 2015).…”

“…Taylor and Xu (1994), Kim, M. and Kim, M. (2003), Kim, I.J. and Kim, S. (2003), Carr and Wu (2007), Chalamandaris and Tsekrekos (2010) and Han et al (2015) examined the dynamics of implied volatilities of options on major currency pairs.…”

Currency Options, Implied Interest Rates and Inflation Targeting

“…Hui and Fong (2015) present the impact of sovereign risk on market expectations of exchange rates through its effect on currency options prices in developed economies, and demonstrate how the implied volatility and options prices change under risk-reversals quoted in the options market. Han, Liang, and Wu (2016) use currency options for three major advanced economy currencies (Euro, British Pound, and Swiss Franc) to determine the relationship between options prices and real economic variables across the countries, showing that the contemporaneous default spreads, domestic and cross country spot market trends as well as historical volatility in the spot and stock markets all impact the implied volatility smile. Sihvonen and Vahamma (2014) use UK interest rate options to demonstrate how market participants accurately price in Libor expectations that align with policy rule variables, and that changes in the expectations reflected in the price are associated with changes in expected inflation and output gap.…”