Option-Implied Volatility Spillovers between Risk Factors in FX Markets and States of the Global Economy

Abstract

This study employs option price data to back out the implied portfolio volatilities of the dollar and carry trade risk factors of the G-10 currencies. To investigate expected volatility spillover effects between risk factors in FX markets, we extend Grobys (2015) and Diebold and Yilmaz (2009) by constructing expected volatility spillover indices based upon the forecast-error variance decomposition of Vector-Autoregression models employing option-implied portfolio volatilities. Surprisingly, the dollar and carry trade risk factors that are orthogonal in the first moment exhibit strong stochastic interrelations in the second expected moment. Our findings indicate that expected high spillover regimes are associated with periods of economic stress.

Keywords: Volatility spillovers, currency markets, G10 currencies, option-implied volatility, risk factors, expected volatility, expected portfolio volatility

JEL Classification: G12, G14