Volatility and the Cross-Section of Returns on FX Options

48 Pages Posted: 28 Mar 2017 Last revised: 21 May 2019

See all articles by Ian W. Marsh

Ian W. Marsh

City University London - Sir John Cass Business School

Jessica James

Risk Advisory Group

Jonathan Fullwood

Bank of England

Menzie David Chinn

University of Wisconsin, Madison - Robert M. La Follette School of Public Affairs and Department of Economics; National Bureau of Economic Research (NBER)

Date Written: June 2, 2017

Abstract

We study the cross-section of returns on FX options sorting currencies based on implied volatilities (IV). Long straddle positions in currencies with low (high) implied volatilities perform well (poorly). A long low IV-short high IV strategy produces large average returns after transactions costs. Total volatility matters rather than any component or transformation of volatility. The returns are distinct from those in the literature on foreign exchange returns or equity option returns and cannot be explained convincingly by standard risk factors. We argue mispricing is caused by cross-sectional differences in hedging demand combined with limits to arbitrage.

Keywords: Options returns, implied volatility, straddles, foreign exchange

Suggested Citation

Marsh, Ian William and James, Jessica and Fullwood, Jonathan and Chinn, Menzie David, Volatility and the Cross-Section of Returns on FX Options (June 2, 2017). Available at SSRN: https://ssrn.com/abstract= or http://dx.doi.org/10.2139/ssrn.2942126

Ian William Marsh (Contact Author)

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

106 Bunhill Row
London, EC1Y 8TZ
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+44 20 7040 5121 (Phone)
+44 20 7040 8881 (Fax)

HOME PAGE: http://www.cass.city.ac.uk/faculty/i.marsh

Jessica James

Risk Advisory Group ( email )

399 Park Avenue
New York, NY 10043
United States

Jonathan Fullwood

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

Menzie David Chinn

University of Wisconsin, Madison - Robert M. La Follette School of Public Affairs and Department of Economics ( email )

1180 Observatory Drive
Madison, WI 53706-1393
United States
608-262-7397 (Phone)
608-262-2033 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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