A Panel Cointegration Analysis of the Dynamics of FX Option Implied Volatility Surface

33 Pages Posted: 2 Feb 2015

See all articles by Hiroaki Suenaga

Hiroaki Suenaga

Curtin University of Technology - School of Economics and Finance; Curtin University - Centre for Research in Applied Economics

Date Written: January 30, 2015

Abstract

Implied volatility surface has been studied extensively for various option markets including equities, foreign currencies, and commodities. Previous studies report that option implied volatility varies across moneyness, maturity, and time, yet, once the level is controlled for, the shape of the volatility surface relative to the volatility implied for at-the-money (ATM) option is stable even over the period of the 1987 stock market crash. This study examines the dynamics of the implied volatility surface for euro-US dollar options, using a recently developed panel cointegration test that allows multiple structural breaks while accounting for cross-sectional dependence. In the model, the option implied volatility Is specified as a quadratic function of ATM volatility, spot and forward rates. The three factors together account for 98 percent of variations in the option implied volatilities across five moneyness, five maturities and over eight years of daily observations from Jan. 2006 to Dec. 2014. The estimated volatility surface however is not stable over time. Rather, its relationship with the three underlying factors exhibits substantial changes around the periods of the Global Financial Crisis and subsequent Euro-zone crisis. This finding is in a stark contrast to previous studies which report the shape of volatility surface is stable over time.

Keywords: Implied volatility, FX, Structural break

Suggested Citation

Suenaga, Hiroaki, A Panel Cointegration Analysis of the Dynamics of FX Option Implied Volatility Surface (January 30, 2015). 2015 Financial Markets & Corporate Governance Conference, Available at SSRN: https://ssrn.com/abstract=2558902 or http://dx.doi.org/10.2139/ssrn.2558902

Hiroaki Suenaga (Contact Author)

Curtin University of Technology - School of Economics and Finance ( email )

GPO Box U 1987
Perth, Western Australia 6845
Australia

Curtin University - Centre for Research in Applied Economics ( email )

GPO Box U1987
Perth, Western Australia 6845
Australia

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