Pricing Currency Options in Tranquil Markets: Modelling Volatility Frowns

Guay Lim, G.M. Martin () and V.L. Martin
Authors registered in the RePEc Author Service: Gael Margaret Martin and Vance Lindsay Martin

No 4/02, Monash Econometrics and Business Statistics Working Papers from Monash University, Department of Econometrics and Business Statistics

Abstract: Volatility smiles arise in currency option markets when empirical exchange rate returns distributions exhibit leptokurtosis. This feature of empirical distributions is symptomatic of turbulent periods when exchange rate movements are in excess of movements based on the assumption of normality. In contrast, during periods of tranquility, movements in exchange rates are relatively small, resulting in unconditional empirical returns distributions with thinner tails than the normal distribution. Pricing currency options during tranquil periods on the assumption of normal returns yields implied volatility frowns, with over-pricing at both deep-in and deep-out-of-the-money contracts and under-pricing for at-the-money contracts. This paper shows how a parametric class of thin-tailed distributions based on the generalized Student t family of distributions can price currency options during periods of tranquility.

Keywords: Option pricing; volatility frowns; thin-tails; generalized Student t. (search for similar items in EconPapers)
JEL-codes: C13 G13 (search for similar items in EconPapers)
Pages: 37 pages
Date: 2002-05
New Economics Papers: this item is included in nep-ecm, nep-ets, nep-fin and nep-ifn
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