The Forecasting Ability of Correlations Implied in Foreign Exchange Options

Posted: 24 Aug 1998

See all articles by José Manuel Campa

José Manuel Campa

University of Navarra - Madrid Campus - IESE Business School; National Bureau of Economic Research (NBER)

P. H. Kevin Chang

Credit Suisse AG - London Headquarters

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Abstract

This paper evaluates the forecasting accuracy of correlation derived from implied volatilities in dollar-mark, dollar-yen, and mark-yen options from January 1989 to May 1995. As a forecast of realized correlation between the dollar-mark and dollar-yen, implied correlation is compared against three alternative forecasts based on time series data: historical correlation, RiskMetrics' exponentially weighted moving average correlation, and correlation estimated using a bivariate GARCH(1,1) model. At the one-month and three-month forecast horizons, we find that implied correlation outperforms, often significantly, these alternative forecasts, which contribute no information beyond that contained in implied correlation. The superiority of the implied correlation forecast holds even when forecast errors are weighted by realized variances, reflecting correlation's contribution to the dollar variance of a multicurrency portfolio.

JEL Classification: G15

Suggested Citation

Campa, José Manuel and Chang, P.H. Kevin, The Forecasting Ability of Correlations Implied in Foreign Exchange Options. Available at SSRN: https://ssrn.com/abstract=6757

José Manuel Campa (Contact Author)

University of Navarra - Madrid Campus - IESE Business School ( email )

Camino del Cerro del Aguila 3
Madrid, 28023
Spain
+34 91 357 0809 (Phone)
+34 91 357 2913 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

P.H. Kevin Chang

Credit Suisse AG - London Headquarters ( email )

One Cabot Square
London E14 4QJ
United Kingdom
+44 171 888 8535 (Phone)
+44 171 888 4775 (Fax)

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