Cross Economic Determinants of Implied Volatility Smile Dynamics: Three Major European Currency Options

Abstract

This paper examines the contemporaneous and lead–lag relationships between economic variables and implied volatility smiles for three major European currency options. We find that cross economic determinants are at least as important as own economic variables in explaining the dynamics of implied volatility smiles. Out‐of‐sample tests also suggest that cross economic variables are important in predicting an economy's currency option smile. These findings suggest that the price impact from cross economic determinants may help fill the gap between the theoretical and the practical implied volatility skews.