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The Economic Determinants of Foreign Exchange Option Smiles

Author HuangChuChu
Tutor HanQian
School Xiamen University
Course Finance
Keywords Implied volatility smiles GBP currency options Economicdeterminants
Type Master's thesis
Year 2014
Downloads 9
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Volatility smiles are an extensively documented cross-sectional feature in the options markets. To model the volatility smile patterns, one way is to focus on relaxing the assumptions of the underlying asset price process in the Black-Scholes valuation framework. Another way is directly examining the economic determinants of the volatility smile patterns. However, very little research has been conducted on directly examining the economic determinants of the volatility smile patterns in foreign exchange option market. An exception is the paper by Gudhus et al.(2003), who only examine the implied volatility skew but kurtosis within the foreign exchange market. Most foreign exchange options are traded over-the-counter (OTC) by large market makers. The conclusions from other market like equity options markets cannot be readily extended to foreign exchange option markets, since these markets differ significantly from each other. And foreign exchange options are widely employed in hedging and risk management, so it is significantly important to study the volatility smile patterns in foreign exchange option market.This paper aims to study the implied volatility patterns using the daily quotes of GBP option (from1/25/2000to6/1/2012). Three questions are addressed in the paper: the shape of the smile, the economic determinants of the shape of the smile and whether these determinants have predictive power for the future shape of the smile or vice versa. Not only the economic determinants of implied volatility skew (risk reversal) but those of kurtosis (butterfly spread) are examined.Based on the daily quotes for GBP option, we find a clear smile pattern in foreign exchange option market. The shape of the smile varies over time and is affected in a dynamic manner by the uncertainty in option market, exchange rate return, short-term and long-term trends of spot exchange rate and yield curve variables and; it also has information about future exchange rate return and spot exchange rate trends. The VAR results show that the long-term trend of spot exchange rate and short-term trend affect the slope and curvature of implied volatility smile in a significant different manner. Our findings are useful for the pricing of derivatives and provide proof for predicting the exchange rate from the perspective of currency option.

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