Spot and Forward Volatility in Foreign Exchange

Lucio Sarno, Pasquale Della Corte and Ilias Tsiakas

No 7893, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: This paper investigates the empirical relation between spot and forward implied volatility in foreign exchange. We formulate and test the forward volatility unbiasedness hypothesis, which may be viewed as the volatility analogue to the extensively researched hypothesis of unbiasedness in forward exchange rates. Using a new data set of spot implied volatility quoted on over-the-counter currency options, we compute the forward implied volatility that corresponds to the delivery price of a forward contract on future spot implied volatility. This contract is known as a forward volatility agreement. We ?nd strong evidence that forward implied volatility is a systematically biased predictor that overestimates movements in future spot implied volatility. This bias in forward volatility generates high economic value to an investor exploiting predictability in the returns to volatility speculation and indicates the presence of predictable volatility term premiums in foreign exchange.

Keywords: Implied volatility; Foreign exchange; Forward volatility agreement; Unbiasedness; Volatility speculation (search for similar items in EconPapers)
JEL-codes: F31 F37 G10 G11 (search for similar items in EconPapers)
Date: 2010-06
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Citations: View citations in EconPapers (2)

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Journal Article: Spot and forward volatility in foreign exchange (2011)
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