The Fine Structure of Currency Returns Implied in One-Touch Options
Posted: 20 May 2019
Date Written: June 10, 2011
Abstract
This article examines the fine structure of risk-neutral currency returns. For this purpose, I specify models comprising pure or time-changed diffusion risk, pure or time-changed jumps, or both. The models are calibrated to vanilla options and subsequently applied to the one-touch option market. Since one-touches are unspanned by a complete set of vanilla options, they lend themselves to a rigorous out-of-sample test. The results suggest that vanilla and one-touch option markets do not generally agree on the fine structure of currency returns: Evidence from the vanilla market favors a complex model with stochastic volatility and jumps, whereas one-touch options imply purely diffusive currency dynamics. This latter finding gives rise to two interpretations. Either, the high activity in currency markets is best reflected by the infinite variation of a diffusive risk factor. Alternatively, the result is an artefact of market makers who anchor their quotes to what the pure diffusion Black-Scholes model implies.
Keywords: Foreign exchange, Lévy process, one-touch option, Monte Carlo simulation, stochastic volatility, jumps
JEL Classification: C63, F31, G13
Suggested Citation: Suggested Citation
Do you have a job opening that you would like to promote on SSRN?
Paper statistics
Recommended Papers
-
Transform Analysis and Asset Pricing for Affine Jump-Diffusions
By Darrell Duffie, Jun Pan, ...
-
Transform Analysis and Asset Pricing for Affine Jump-Diffusions
By Darrell Duffie, Jun Pan, ...
-
The Impact of Jumps in Volatility and Returns
By Michael S. Johannes, Bjorn Eraker, ...
-
Implied Volatility Functions: Empirical Tests
By Bernard Dumas, Jeff Fleming, ...
-
Recovering Risk Aversion from Option Prices and Realized Returns
-
Recovering Probabilities and Risk Aversion from Option Prices and Realized Returns
-
Stock Return Characteristics, Skew Laws, and the Differential Pricing of Individual Equity Options
By Gurdip Bakshi, Nikunj Kapadia, ...
-
Stock Return Characteristics, Skew Laws, and the Differential Pricing of Individual Equity Options
By Nikunj Kapadia, Gurdip Bakshi, ...
-
Nonparametric Estimation of State-Price Densities Implicit in Financial Asset Prices
By Yacine Ait-sahalia and Andrew W. Lo
