A TEST OF EFFICIENCY FOR THE CURRENCY OPTION MARKET USING STOCHASTIC VOLATILITY FORECASTS

Dajiang Guo
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Dajiang Guo: Centre Solutions, Zurich Group, One Chase Manhattan Plaza, New York, NY 10005, USA and Institute for Policy Analysis, University of Toronto, Toronto, Canada, M5S 3G6, Canada

Chapter 12 in Quantitative Analysis in Financial Markets:Collected Papers of the New York University Mathematical Finance Seminar, 1999, pp 292-311 from World Scientific Publishing Co. Pte. Ltd.

Abstract: AbstractThe conditional volatility of foreign exchange rates can be predicted with GARCH models, and with implied volatility extracted from currency options. This paper investigates whether the difference in these predictions is economically meaningful. In an efficient market, after accounting for transaction costs and risk, no trading strategy should earn abnormal risk-adjusted returns. In the absence of transaction costs, both the delta-neutral and the straddle trading strategies lead to significant positive economic profits against the option market, regardless of which volatility prediction method is used. The agent using the Implied Stochastic Volatility Regression method (ISVR) earns larger profits than the agent using the GARCH method. However, after accounting for transaction costs assumed to equal one percent of market prices, observed profits are not significantly different from zero in most trading strategies; the exception is for an agent using the ISVR method with a 5% price filter.

Date: 1999
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