Forecasting Implied Volatility in Foreign Exchange Markets: A Functional Times Series Approach
The European Journal of Finance, Forthcoming
31 Pages Posted: 2 Apr 2015 Last revised: 21 Dec 2016
Date Written: February 23, 2016
We utilise functional time series (FTS) techniques to characterise and forecast implied volatility in foreign exchange markets. In particular, we examine the daily implied volatility curves of FX options, namely; EUR-USD, EUR-GBP, and EUR-JPY. Based on existing techniques in the literature, the FTS model is shown to produce both realistic and plausible implied volatility shapes that closely match empirical data during the volatile 2006-2013 period. Furthermore, the FTS model significantly outperforms implied volatility forecasts produced by traditionally employed parametric models. The evaluation is performed under both an in-sample and out-of-sample testing framework with our findings shown to be robust across various currencies, moneyness segments, contract maturities, forecasting horizons, and out-of-sample window lengths. The economic signicance of the results is highlighted through the implementation of a simple trading strategy.
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