Abstract
This study introduces the intraday implied volatility (IV) for pricing the Australian dollar (AUD) options. The IV is estimated using the at-the-money one-month, two-month, and three-month maturity AUD options traded in the opening, midday, and closing period of a trading day. The Mincer-Zarnowitz regression test evaluates the predictive power of IV to forecast the foreign exchange volatility for the within-week, one-week, and one-month horizon. The mean absolute error, mean squared error, and root mean squared error measures are employed to assess the performance of IV in estimating the price of currency options for the within-week, one-week, and one-month horizon. This study reveals four critical findings. First, a three-month maturity IV does not contain vital information for pricing options. Second, IV incorporated information is not relevant to compute the value of options for a horizon of less than a week. Third, IV in the closing period of Monday or Tuesday subsumes most of the essential information to estimate options price. Fourth, the shorter (longer) maturity IV provides critical information to price options for the shorter (longer) horizon. The intraday IV is a new dimension of unobservable volatility in accurately pricing currency options for researchers and practitioners.
Highlights
This study introduces intraday implied volatility (IV) which is an innovative approach to estimate the volatility of underlying currency for pricing currency options accurately.The intraday IV captures the market information at the opening, midday, and closing period of a trading day for pricing options with higher accuracy
The 2019 Bank for International Settlement (BIS) Triennial Survey results reveal that the turnover in Australian dollar (AUD) options increased by 58 percent between April 2016 and April 2019 [1], which is significant compared to other currency options
The purpose of this paper is to investigate the performance of the intraday implied volatility (IV) for pricing the Australian dollar (AUD) options
Summary
This study introduces intraday implied volatility (IV) which is an innovative approach to estimate the volatility of underlying currency for pricing currency options accurately.The intraday IV captures the market information at the opening, midday, and closing period of a trading day for pricing options with higher accuracy. If the options are mispriced, overpriced options, it will increase the cost for hedging using currency options. Australian dollar options are considered to assess the capability of intraday IV to holding appropriate market information for pricing options precisely. Holding currency options for various investment decisions such as hedging or speculation can be costly if the options are mispriced. Options mispricing affects the selection of hedge ratio, hedging efficiency, as well as expected hedging costs [4]. For this reason, the accuracy of currency options pricing has been attracting the attention of market participants [5]. The most commonly used model to calculate European options prices is known as the Black–Scholes [6] (BS)
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