Forecasting day-ahead expected shortfall on the EUR/USD exchange rate: The (I)relevance of implied volatility

Abstract

The existing literature provides mixed results on the usefulness of implied volatility for managing risky assets, while evidence for expected shortfall predictions is almost nonexistent. Given its forward-looking nature, implied volatility might be more valuable than backward-looking measures of realized price fluctuations. Conversely, the volatility risk premium embedded in implied volatility leads to overestimating the observed price variation. This paper explores the benefits of augmenting econometric models used in forecasting the expected shortfall, a risk measured endorsed in the Basel III Accord, with information on implied volatility obtained from EUR/USD option contracts. The day-ahead forecasts are obtained from several classes of econometric models: historical simulation, EGARCH, quantile regression-based HAR, joint VaR and ES model, and combination forecasts. We verify whether the resulting expected shortfall forecasts are well-specified and test the models’ accuracy. Our results provide evidence that the information provided by forward-looking implied volatility is more valuable than that in backward-looking realized measures. These results hold across multiple model specifications, are stable over time, hold under alternative loss functions, and are more pronounced during periods of higher market uncertainty when risk modeling matters most.