Abstract
This study examines the predictive power of implied volatility smirk to forecast foreign exchange (FX) return. The volatility smirk contains critical information, especially when the market experiences negative news. The Australian dollar, Canadian dollar, Swiss franc, Euro, and British pound options traded in the opening, midday and closing periods of the trading day are selected to estimate the currency smirk. Research results reveal that the currency smirk outperforms in forecasting FX returns. In addition, the steeper slope in the middle of the trading day suggests that the predictive power of currency smirk in the midday period is higher compared to the opening and closing periods. However, currency smirks’ predictability lasts for a short period, as the FX market is highly adept at incorporating the vital information embedded in the currency smirk. These findings imply that the currency smirk is distinctive for forecasting very short-term FX fluctuations, and the day- or overnight FX traders can use its uniqueness to profit from quick price swings in the 24-hour global FX market.
Highlights
The implied volatility (IV) smirk is the difference between the IV of out-of-the-money (OTM) put options and the IV of at-the-money (ATM) call options
This study is justified based on the consideration that the stock market and the foreign exchange (FX) market are analogous in the context of financial assets for investment purposes, and exchange-traded stock and currency options have the same maturity
Under the in-sample test, the significant slope coefficient for the individual and the whole sample in Table 3 indicates that there is a relationship between currency smirk and FX return, which supports the justification of this study
Summary
The implied volatility (IV) smirk is the difference between the IV of out-of-the-money (OTM) put options and the IV of at-the-money (ATM) call options. The steeper slope in the middle of the trading day suggests that the predictive power of currency smirk in the midday period is higher compared to the opening and closing periods.
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