Options trading profits from correlation forecasts

James Chong

Applied Financial Economics, 2004, vol. 14, issue 15, 1075-1085

Abstract: This study examines the profitability of trading currency straddles on the basis of the volatility and correlation forecasts derived from various statistical models. There is evidence to demonstrate that for maximum wealth accumulation, a trader should employ sophisticated models like the exponential GARCH for correlation forecasts and simpler ones like the exponential weighted moving average for volatility forecasts. With differing transaction costs structure between traders, the directional bets taken by the models of the market maker for the most part appear successful, reaping large positive returns. This is especially evident for GBP/DEM straddles and to a lesser extent for JPY/DEM straddles. However, the options trading strategy profits of the price taker are insufficient to outweigh transaction costs, a result considered consistent with market efficiency.

Date: 2004
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DOI: 10.1080/0960310042000281194

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