Currency Options Market Research Articles

Market turbulence and investor decision-making in currency option market

This research delves into the effects of recent crises on investor behavior within the currency options market, particularly focusing on the relationship with underlying exchange rates. Analyzing daily EUR/USD currency call pair data from May 4, 2011, to June 19, 2023, we employ a genetic algorithm to calculate stochastic volatility in line with the Garman and Kohlhagen model. Through the application of the STAR model, we identified shifts in investor behavior across various crisis periods. These shifts are linked to inherent asymmetries in the time series data, illustrating the diverse strategies of different investor types, such as fundamentalists and chartists. Our findings reveal how each investor group tailors its approach to these market asymmetries, showcasing distinct strategies and responses to fluctuating market conditions and crises. This study contributes to the financial literature by offering a more nuanced understanding of how crises influence investor behavior and the dynamics of currency markets. Ultimately, it sheds light on the complexities of investor behavior during economic challenges.

통화옵션과 국채선물이 원달러환율에 미치는 영향

In this study, the impact of currency options(volatility) and KTB futures prices on the USD/KRW exchange rate was divided into before and after COVID-19 and a comparative analysis was conducted using cross-sectional regression analysis and VECM. The analysis results are as follows. First, looking at the results of the regression analysis, the currency option market showed that only the one-year volatility of the currency option affected the USD/KRW exchange rate in all periods. However, both 3-year and 10-year KTB futures had no significant impact before COVID-19, but appeared to have a statistically significant impact on the exchange rate starting after COVID-19. Second, cointegration exists in all time series before and after COVID-19, and in particular, it can be seen that the cointegration correlation is stronger after COVID-19 than before. Third, the results of the VECM analysis showed that the influence of KTB futures had no significance before COVID-19, but became significant after COVID-19. Fourth, the results of the shock response analysis showed that the impact of shocks in the options market and KTB futures market on the USD/KRW exchange rate was greater after COVID-19 than before and had a long lasting effect. Fifth, the results of the variance decomposition of forecast errors for the USD/KRW exchange rate also showed that the influence on KTB futures increased more after COVID-19 than before. Understanding foreign exchange is very important not only for exports and imports, but also for international trade and global economic activities. In the future, we hope that more in-depth research on the foreign exchange market and international trade will continue.

Interaction between Sovereign Quanto Credit Default Swap Spreads and Currency Options

This study analyzes the term structures of sovereign quanto credit default swap (CDS) spreads and currency options, which are driven by anticipated currency depreciation risk following sovereign credit default (Twin Ds). We develop consistent pricing models for these instruments using a jump-diffusion stochastic volatility model, which allows us to decompose the term structure into the risk components. We find a common risk factor between the intensity process of sovereign credit risk and the stochastic volatility of the exchange rate, and the depreciation risk mainly captures the dependence structure between these markets during periods of high market stress in the Eurozone countries. Depreciation risk is an important component of sovereign quanto CDS spreads and is evident in the negative slope of the volatility smile in the currency option market.

Investor behavior in the currency option market during the COVID-19 pandemic

This study investigates the COVID-19 pandemic's impact on investor behavior in the currency options market, emphasizing its relationship with underlying exchange rates. Using a sample of daily data from select futures continuous calls from September 22, 2016, to December 31, 2021, we introduce a novel variable, “market imperfections,” to quantify the gap between observed and theoretical currency option prices based on the Garman and Kohlhagen model. Through the application of a Markov switching model, we identify pandemic-related changes in investor behavior, characterized by patterns of divergence and convergence. Our research distinguishes between two key behavioral types in the market: fundamentalists and chartists. This study enriches the literature by clarifying how crises, specifically the COVID-19 period, influence investor dynamics and affect market responses. Overall, we provide critical insights into the factors shaping behavior during challenging periods.

Semivariance and Semiskew Risk Premiums in Currency Markets

Using the model-free methodology proposed in the literature, variance and skew swaps are extracted from currency options for several foreign exchange rates. Moreover, these variables are decomposed into semivariance and semiskew swaps, which are conditional to the evolution of the foreign exchange rate, and it is shown to have higher explanatory power for currency excess return. These semivariances enable the definition of a variance-skew swap that also possesses a strong explanatory power for currency excess return. From these variables, higher moment semi-risk premiums can be computed and measure how tail risks are priced. These semivariance and semiskew swaps better explain the currency excess return than the standard or undecomposed ones. For semivariance swaps, both the up and down contracts are equally informative while for semiskew swaps only the down tail related one is. Down semivariance and semiskew swaps carry complementary information regarding the currency excess return. Trimming these variables enables us to show that extreme movements affecting the currency option market contain no information on the evolution of the currency. Lastly, forecasting tests further illustrate the importance of decomposing the variance and skew swaps into semi components as it improves significantly the results.

Dynamic Interactions between Government Bonds and Exchange Rate Expectations in Currency Options

This paper examines the dynamic interactions between the government bond yields of Germany, Japan and the US and their exchange rate expectations anticipated in the currency options, i.e., risk reversals (put premia) of the US dollar versus the yen and euro. Short-term, one-way information flow from the government bond market to the currency option market was substantial before the introduction of quantitative easing by the US Fed in response to the 2008 global financial crisis; this pattern diminished after the 2013 taper tantrum. The long-term bond yields are important and separable determinants of the risk reversals. The negative relationship between the spreads of the US Treasury yield over the other two countries’ bond yields, and the dollar risk reversals indicating a fall in US dollar interest rate, implies dollar depreciation expectations embedded in currency option prices, not an appreciation, as predicted by uncovered interest rate parity.

Overreactions in the Foreign Currency Options Market

AbstractThe seminal research by Stein (Journal of Finance 1989, 44, 1011) shows that long‐term options overreact to short‐term volatility shocks. In contrast, recent studies show that such irrational responses disappear when model‐free implied volatilities are used. We extend this literature by examining overreactions in the over‐the‐counter currency options market. Using model‐free implied volatility and by considering the estimated structural breaks around recent financial crises, we find consistent evidence for volatility overreactions during non‐crisis periods but no conclusive evidence of such behavior during recent crises periods. Overall, our findings suggest that it is crucial to consider structural changes when testing for overreactions in options markets.

European Option Pricing With a Fast Fourier Transform Algorithm for Big Data Analysis

Several empirical studies show that, under multiple risks, markets exhibit many new properties, such as volatility smile and cluster fueled by the explosion of transaction data. This paper attempts to capture these newly developed features using the valuation of European options as a vehicle. Statistical analysis performed on the data collected from the currency option market clearly shows the coexistence of mean reversion, jumps, volatility smile, and leptokurtosis and fat tail. We characterize the dynamics of the underlying asset in this kind of environment by establishing a coupled stochastic differential equation model with triple characteristics of mean reversion, nonaffine stochastic volatility, and mixed-exponential jumps. Moreover, we propose a characteristic function method to derive the closed-form pricing formula. We also present a fast Fourier transform (FFT) algorithm-based numerical solution method. Finally, extensive numerical experiments are conducted to validate both the modeling methodology and the numerical algorithm. Results demonstrate that the model behaves well in capturing the properties observed in the market, and the FFT numerical algorithm is both accurate and efficient in addressing large amount of data.

Predictability of Implied Volatility: Evidence from the Over-the-counter Currency Option Markets

This paper provides an empirical study on the predictability of implied volatility using dataset collected from the London over-the-counter currency option market. The present work is motivated by the lack of empirical studies that address implied volatility characteristics across various maturities. We applied both in and out-of-sample tests that include the nonparametric variance ratio and interval forecasts methodologies. Contrary to the weak-form market efficiency theory, this study provides evidence of non-random movement in the implied volatility series and indicates predictability of implied volatility series. The result suggests that there is a need to account for the differences in data characteristics that exist across the volatility term structure.

Equilibrium valuation of currency options under a jump-diffusion model with stochastic volatility

In this paper, we continue to investigate the model related to Bakshi and Chen (1997). In our model, both of the money supplies in the two countries are assumed to follow jump-diffusion processes with stochastic volatility. In the set of the two-country economy, we obtain the equilibrium price of the nominal exchange rate. With the help of Fourier transform to solve a partial integro-differential equation (PIDE), we get a closed-form solution to the PIDE for a European call currency option. We also do Monte Carlo simulations to verify the correctness of the derived formula. Our model contains some existing currency option models as special cases, for example the stochastic-volatility jump-diffusion (SVJD) model in Bates (1996), in which the jump of the exchange rate is driven by one Poisson process. We also provide some numerical analysis to show that our model is effective to the foreign currency option market.

Understanding Delta-Hedged Option Returns in Stochastic Volatility Environments

In this paper, we provide a novel representation of delta-hedged option returns in a stochastic volatility environment. The representation of delta-hedged option returns provided in this paper consists of two terms: volatility risk premium and parameter estimation risk. In an empirical analysis, we examine delta-hedged option returns based on the result of a historical simulation with the USD-JPY currency option market data from October 2003 to June 2010. We find that the delta-hedged option returns for OTM put options are strongly affected by parameter estimation risk as well as the volatility risk premium, especially in the post-Lehman shock period.

A Chaos Expansion Approach Under Hybrid Volatility Models

In this paper, we propose an approximation method based on the Wiener-Ito chaos expansion for the pricing of European contingent claims. Our method is applicable to widely used option pricing models such as local volatility models, stochastic volatility models, and their combinations. This method is useful in practice since the resulting approximation formula is not computationally expensive, hence it is suitable for calibration purposes. We will show through some numerical examples that our approximation remains quite high even for the long maturity and/or the high volatility cases, which is a desired feature. As an example, we propose a hybrid volatility model and apply our approximation formula to the JPY/USD currency option market and obtain very accurate results.

A chaos expansion approach under hybrid volatility models

In this paper, we propose an approximation method based on the Wiener–Ito chaos expansion for the pricing of European contingent claims. Our method is applicable to widely used option pricing models such as local volatility models, stochastic volatility models and their combinations. This method is useful in practice since the resulting approximation formula is not computationally expensive, hence it is suitable for calibration purposes. We will show through some numerical examples that our approximation remains quite good even for the long maturity and/or the high volatility cases, which is a desired feature. As an example, we propose a hybrid volatility model and apply our approximation formula to the JPY/USD currency option market obtaining very accurate results.

Liquidity in Currency Options Market in India

Liquidity being an elusive concept is often difficult to measure, and it becomes even vaguer in currency options market which provides investors an alternative to hedge against foreign exchange fluctuations. Over past few years since the starting of trading of currency options contracts on US dollar-Indian rupee in Indian exchanges began, the currency market has grown significantly. Currency options trades at the National Stock Exchange of India is ranked first among exchanges across the world in terms of volume traded and number of trades, and third in terms of traded value (WFE, 2011). Hence, in this paper, we examine the systematic component of liquidity as source of price changes in the Indian currency options market. Using daily data on trading volume, value, open interest, and spot USD-INR exchange rate from November 2010 to October 2012, we compute the Amihud ratio (Amihud, 2002) as a proxy for market-level illiquidity in the Indian currency options market. Vector error correction model (VECM) estimation approach is employed to examine the causal relationship among illiquidity, volatility, returns and speculation in currency options market. Specifically, we aim to address the following issues with respect to the currency options market for USD-INR: (1) What makes the liquidity in the currency options market suddenly dry up? (2) How is the liquidity in the currency options market related to volatility? and (3) Does speculators’ capital drive the currency options market?

Liquidity as an Information Signal: Evidence from Currency Options Market in India

Liquidity as an Information Signal: Evidence from Currency Options Market in India

Asia-Pacific Currency Options Pricing Analysis

During the Global Financial Crisis (GFC), the Asia-Pacific currencies, the Australian dollar (AUD) and the Japanese yen (JPY), behaved differently. The AUD depreciated and the JPY appreciated by 30% and 17%, respectively, against the US dollar. This contradictory price movement increased the demand for AUD and JPY options for use as speculations and hedging tools. This was a concern for the participants in the foreign exchange (FX) market, specifically for hedgers, who suffer financial losses when options are mispriced. This study, therefore, examines the post GFC Asia-Pacific currency options market efficiency to ensure that the AUD and JPY options are priced accurately. We develop a new econometric method with the idea that the call and put hold the price where it should be if their price difference is equal to the return from their moneyness. The overall test results suggest that, on average, the Asia-Pacific currency options market is efficient, thus suggesting that the underlying AUD and JPY currency markets are relatively stable. Our findings imply that European investors consider the AUD and JPY as safe-haven currencies in the post GFC European debt crisis period.

The Information Content of the Implied Volatility in OTC Individual Stock Options Market

This paper investigates the information content of implied volatilities inferred from individual stock options quoted over-the-counter (OTC). First, we examine whether the implied volatility has better explanatory power than historical volatility for forecasting future realized volatility of the underlying stock return. Next, we analyze the properties of volatility spreads, the difference between implied volatilities and realized volatilities. Using near-the-money options for 10 firms over the sample period from April 2005 to April 2010, we first demonstrate that the implied volatilities for most firms don’t have additional information beyond what are already contained in historical volatilities. However, the implied volatilities with some specific remaining maturities for two firms dominate historical volatilities in explaining the future realized volatilities. Second, we find that during the period before global financial crisis, the implied volatilities are systematically lower than the future realized volatilities whereas this reversal disappears after the year 2008. This finding suggests that there’s a possibility of the risk loving behavior of the investors in OTC individual stock options market during the pre-global crisis period. Finally, through the comparative analysis of the KOSPI200 index options quoted OTC over the same sample period, we conclude that the OTC individual stock options market has distinctive characteristics like the KRW/USD OTC currency options market.

The Effect of Capital Flow Management Measures in Five Asian Economies on the Foreign Exchange Market

This paper examines the effects of the capital flow management measures (CFMs) introduced by five Asian economies (Indonesia, Korea, Malaysia, the Philippines and Thailand) to deal with large capital inflows on the foreign exchange market. Using the GARCH methodology, this paper models the changes in these economies’ exchange rates against the US dollar with the eight CFMs from February 2010 to March 2011 as the focal explanatory variable. The empirical results show that four CFMs stabilized the exchange rates by reducing exchange rate volatility and one had an effect on the exchange rate level. However, their effects on the currency option market were mixed.

Crash risk of the euro in the sovereign debt crisis of 2009–2010

The economic-political instability of a country, which is tied to its credit risk, often leads to sharp depreciation and heightened volatility in its currency. This paper shows that not only the creditworthiness of the euro-area countries with weaker fiscal positions but also that of the member countries with more sound fiscal positions are important determinants of the deep out-of-the-money euro put option prices, which embedded information on the euro crash risk during the sovereign debt crisis of 2009–2010. We also find evidence of information flow from the sovereign credit default swap market to the currency option market during the crisis.

Econometric Modeling for Transaction Cost-Adjusted Put-Call Parity: Evidence from the Currency Options Market

Due to the mispricing of options, no-arbitrage condition put-call parity (PCP) violations lead to inefficiency in the currency options market. Through transaction costs, the effects of these violations are reduced to negligible levels, indicating that PCP is not a sufficient condition for an options market efficiency test. Thus, this study developed a transaction cost-adjusted put-call parity (TC-Adj-PCP) econometric model to examine the efficiency of options markets. The fundamental analysis of the proposed model concludes that transaction costs represent an omitted variable for the PCP model, where the uniqueness of this variable is demonstrated under PCP in the context of options market efficiency. The novelty of the TC-Adj-PCP model resolves controversial transaction costs issues for traders and researchers.