Abstract
We study the cross-section of returns on FX options sorting currencies based on implied volatilities (IV). Long straddle positions in currencies with low (high) implied volatilities perform well (poorly). A long low IV-short high IV strategy produces large average returns after transactions costs. Total volatility matters rather than any component or transformation of volatility. The returns are distinct from those in the literature on foreign exchange returns or equity option returns and cannot be explained convincingly by standard risk factors. We argue mispricing is caused by cross-sectional differences in hedging demand combined with limits to arbitrage.
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