Volatility and the Cross-Section of Returns on FX Options
48 Pages Posted: 28 Mar 2017 Last revised: 5 Jun 2017
Date Written: June 2, 2017
We sort currencies based on their implied volatilities and show that buying straddles on currencies with relatively low (high) implied volatilities leads to good (poor) performance. The mean return on a long straddle position in the currency with the lowest implied volatility at the initiation of the position is 25% per month. The mean return on a long straddle on the currency with the highest implied volatility is -14% per month. The long-short strategy returns 34% per month after accounting for transactions costs, an annualised Sharpe ratio of 1.04. We show that total volatility matters rather than some key component or transformation of volatility. The returns earned from long-short straddle positions based on implied volatility ranks are distinct from those documented in the literature on foreign exchange (or equity) returns to date and cannot be explained by standard risk factors or proxies for limits to arbitrage.
Keywords: Options returns, implied volatility, straddles, foreign exchange
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