Overreactions in the Foreign Currency Options Market

Abstract

The seminal research by Stein (Journal of Finance 1989, 44, 1011) shows that long‐term options overreact to short‐term volatility shocks. In contrast, recent studies show that such irrational responses disappear when model‐free implied volatilities are used. We extend this literature by examining overreactions in the over‐the‐counter currency options market. Using model‐free implied volatility and by considering the estimated structural breaks around recent financial crises, we find consistent evidence for volatility overreactions during non‐crisis periods but no conclusive evidence of such behavior during recent crises periods. Overall, our findings suggest that it is crucial to consider structural changes when testing for overreactions in options markets.