Predictability in Implied Volatility Surfaces: Evidence from the Euro OTC FX Market

European Journal of Finance, vo. 20, no. 1, pp.33-58, 2014.

36 Pages Posted: 12 May 2012 Last revised: 28 May 2014

See all articles by George Chalamandaris

George Chalamandaris

Athens University of Economics and Business - Department of Accounting and Finance

Andrianos E. Tsekrekos

Athens University of Economics and Business - Department of Accounting and Finance

Date Written: February 6, 2012

Abstract

Recent general equilibrium models prescribe predictable dynamics in the volatility surfaces that are implied by observed option prices. In this paper we investigate the predictability of surfaces, using extensive time series of implied volatilities from over-the-counter options on eight different currencies, quoted against the Euro. We examine implied volatility surfaces in the context of predictability through three different models, two that employ parametric specifications to describe the surface and one that decomposes it into latent statistical factors. All examined models are shown to [a] accurately describe the surfaces in-sample, and [b] produce forecasts that are superior to hard-to-beat benchmarks that ignore information about the shape of the surface, in medium to long-term horizons. We show that these forecasts can support profitable volatility trading strategies in the absence of transaction costs. Comparing across competing models, our results suggest that parametric models, that allow for a more structured description of the surface, are more successful in terms of forecasts' accuracy and significance of trading profits.

Keywords: Exchange rates, Implied volatility surfaces, Volatility functions, Forecasting, Foreign exchange options

JEL Classification: C53, G13, F37

Suggested Citation

Chalamandaris, George and Tsekrekos, Andrianos E., Predictability in Implied Volatility Surfaces: Evidence from the Euro OTC FX Market (February 6, 2012). European Journal of Finance, vo. 20, no. 1, pp.33-58, 2014., Available at SSRN: https://ssrn.com/abstract=2056314

George Chalamandaris

Athens University of Economics and Business - Department of Accounting and Finance ( email )

76 Patission Street
GR-104 34 Athens
Greece

Andrianos E. Tsekrekos (Contact Author)

Athens University of Economics and Business - Department of Accounting and Finance ( email )

76 Patission Street
GR-104 34 Athens
Greece

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