A Proposed Solution for the Chicken-Egg Dilemma in Pricing Currency Options

Australasian Accounting Business and Finance Journal, 7(2), 2013, 71-86

18 Pages Posted: 23 Jan 2014

See all articles by Ariful Hoque

Ariful Hoque

Murdoch University

Chandrasekhar Krishnamurti

University of South Australia

Date Written: March 29, 2012

Abstract

The implied volatility (IV) estimation process suffers from an obvious chicken-egg dilemma: obtaining an unbiased IV requires the options to be priced correctly and calculating an accurate option price requires an unbiased IV. We address this critical issue in two steps. First, the Granger causality test is employed, which confirms the chicken-and-egg problem in the IV computing process. Secondly, the concept of “moneyness volatility (MV)” is introduced as an alternative to IV. MV is modeled based on an option’s moneyness during the life of the option’s contract. The F-test, Granger-Newbold test and Diebold-Mariano test results consistently show that MV outperforms IV in estimating the exchange rate volatility for pricing options. Further, these series of tests across six major currency options substantiate the validity as well as the reliability of the results. We posit that MV offers a unique solution for pricing currency options accurately.

Keywords: Currency options pricing, implied volatility, moneyness volatility, Granger causality test, Granger-Newbold test, Diebold-Mariano test

JEL Classification: G13, G17

Suggested Citation

Hoque, Ariful and Krishnamurti, Chandrasekhar, A Proposed Solution for the Chicken-Egg Dilemma in Pricing Currency Options (March 29, 2012). Australasian Accounting Business and Finance Journal, 7(2), 2013, 71-86, Available at SSRN: https://ssrn.com/abstract=2382923

Ariful Hoque

Murdoch University ( email )

South Street
Murdoch 6150, Western Australia 6105
Australia

Chandrasekhar Krishnamurti (Contact Author)

University of South Australia ( email )

37-44 North Terrace, City West Campus
Adelaide, South Australia 5001
Australia

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