Spot and Forward Volatility in Foreign Exchange

42 Pages Posted: 19 Jul 2010

See all articles by Pasquale Della Corte

Pasquale Della Corte

Imperial College Business School; Centre for Economic Policy Research (CEPR)

Lucio Sarno

City University London - Sir John Cass Business School; Centre for Economic Policy Research (CEPR)

Ilias Tsiakas

University of Guelph

Multiple version iconThere are 2 versions of this paper

Date Written: June 2010

Abstract

This paper investigates the empirical relation between spot and forward implied volatility in foreign exchange. We formulate and test the forward volatility unbiasedness hypothesis, which may be viewed as the volatility analogue to the extensively researched hypothesis of unbiasedness in forward exchange rates. Using a new data set of spot implied volatility quoted on over-the-counter currency options, we compute the forward implied volatility that corresponds to the delivery price of a forward contract on future spot implied volatility. This contract is known as a forward volatility agreement. We find strong evidence that forward implied volatility is a systematically biased predictor that overestimates movements in future spot implied volatility. This bias in forward volatility generates high economic value to an investor exploiting predictability in the returns to volatility speculation and indicates the presence of predictable volatility term premiums in foreign exchange.

Keywords: Foreign Exchange, Forward Volatility Agreement, Implied Volatility, Unbiasedness, Volatility Speculation

JEL Classification: F31, F37, G10, G11

Suggested Citation

Della Corte, Pasquale and Sarno, Lucio and Tsiakas, Ilias, Spot and Forward Volatility in Foreign Exchange (June 2010). CEPR Discussion Paper No. DP7893. Available at SSRN: https://ssrn.com/abstract=1640970

Pasquale Della Corte (Contact Author)

Imperial College Business School ( email )

South Kensington Campus
Exhibition Road
London, SW7 2AZ
United Kingdom
+44(0)20 759 49331 (Phone)

HOME PAGE: http://sites.google.com/view/pasqualedellacorte

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Lucio Sarno

City University London - Sir John Cass Business School ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Ilias Tsiakas

University of Guelph ( email )

Department of Economics and Finance
University of Guelph
Guelph, Ontario N1G 2W1
Canada
5198244120 ext 53054 (Phone)
5197638497 (Fax)

HOME PAGE: http://www.uoguelph.ca/~itsiakas

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