Analysing Intraday Implied Volatility for Pricing Currency Options

Foreign currency options are one of the significant developments in the financial derivative markets. The currency options do not substitute the forward or futures contracts but use as a more versatile financial derivative. It can offer the opportunities and advantages to those seeking protection from financial distress resulting from the movement of foreign exchange (FX) rate. Over the past four decades, the currency options employ as a hedging tool and for speculative purposes has significantly grown into a majority of foreign exchange activity. It can be traded on a regulated exchange where they are sold in a standardised form by managing the underlying currency contract size, strike price, and expiration date. However, over-the-counter (OTC) options are allowed for customisation of the terms of the options contract for contract size, strike price, and date of maturity. This chapter discusses currency options’ mechanics, development of currency options market, research objectives and hypotheses, and thesis structure.

This section reviews the performance of implied volatility (IV) in forecasting volatility and pricing options in different markets in the existing literature. This study involves a rigorous literature review to identify the research gaps and discover the potential of intraday IV to forecast volatility of foreign exchange and pricing currency options. First, the literature review focuses on the performance of IV to forecast volatility of the stock, stock index, and currency market. Several empirical studies analyse the performance of only daily IV in forecasting volatility. Therefore, the performance of intraday IV to forecast volatility is one of the critical issues in this study. Second, we examine the literature on the RV to confirm that it is appropriate to use as a proxy for the actual volatility. The appropriateness of RV for an alternative of actual volatility is critical since the performance of intraday IV is evaluated through forecasting RV. Third, this study investigates the literature, and no significant research has been found on the IV for pricing options. However, the IV is widely accepted in the literature that the information content embedded in IV is vital to forecast the volatility of the underlying asset of options. Thus, a potential research issue that is evaluating the performance of IV to estimate the price of currency options by using it as input for the options pricing model. Fourth, the literature focuses on the biasedness of the options pricing model, which has an impact on the performance of IV for pricing currency options.

This chapter first discusses the methodology to test the 18 hypotheses that have been developed in Chap. 1. For hypothesis 1–9, the methods are used to (a) estimate the IV based on the ATM price of call and put options with 1-, 2-, and 3-month maturity during the opening, midday, and closing period of a trading day, (b) estimate the RV for the underlying currency of options and using it as the proxy for the actual foreign exchange volatility, and (c) analyse the performance of IV to forecast RV for the within-week, 1-week, and 1-month forecast horizon. For hypothesis 10–18, the procedures are employed to (a) calculate the call options model price (CMOD) and put options model price (PMOD) using the ATM estimated IV as input for the options pricing model, and (b) compare the CMOD and PMOD with the call and put options market price, respectively, evaluating the performance of IV to estimate the price of currency options for the within-week, 1-week, and 1-month estimate horizon. Finally, the details of the data are described in this chapter.

This chapter conducts an empirical analysis of IV to forecast the RV through testing hypothesis 1–9. The analysis includes three steps. First, estimate the IV for ATM price of currency options with 1-, 2-, and 3-month maturity during opening, midday, and closing period. Second, estimate the RV of currency to use as the proxy for the actual volatility. Finally, assess the performance of IV to forecast RV accurately for the within-week, 1-week, and 1-month forecast horizon. The findings indicate that the IV with different options maturity subsumes the relevant information of underlying currency volatility for different forecast horizons. IV obtained from the early of a week (Monday or Tuesday) and later of a week (Thursday) contain relevant information to forecast RV for the within-week forecast horizon. The information content embedded in IV from early of a week (Monday or Tuesday) is informative to forecast RV for the 1-week and 1-month forecast horizon.

This chapter conducts empirical analysis in two steps for testing hypothesis 10–18 through the methodology developed in Chap. 3. First, calculate the call options model price (CMOD) and put options model price (PMOD) using the ATM 1-, 2-, and 3-month maturity IV obtained during the opening, midday, and closing period of a trading day as input for BS options pricing model. Second, estimate the options model pricing error by comparing the CMOD and PMOD with the call and put options market price, respectively, to evaluate the performance of IV for pricing currency options accurately, for the within-week, 1-week, and 1-month estimate horizon. Further, the within-week estimate horizon indicates that the IV is estimated 1–4 days before the date of pricing currency options. Similarly, the 1-week and 1-month estimate horizon imply that the IV is estimated 1-week and 1-month before the date of pricing currency options, respectively. The findings indicated that the 2-month maturity IV from early of a week (Monday or Tuesday) and 1-month maturity IV from later of a week (Thursday) in the closing trading period contain relevant information to calculate the value of currency options for the within-week estimate horizon. The 1-month maturity IV from early of a week (Monday or Tuesday) in the closing trading period holds appropriate information to price currency options price for the 1-week estimate horizon. The 2-month maturity IV from early of a week (Monday or Tuesday) in the closing trading period subsumes vital information to compute the value of currency options for the 1-month estimate horizon.

The empirical analysis is conducted for testing hypotheses 1–9 and hypotheses 10–18 in Chaps. 4 and 5, respectively, and a summary of the results is discussed in this chapter to conclude the thesis. The empirical findings in Chap. 4 based on the analysis (a) IV forecast RV for the underlying currency of options for the within-week horizon, (b) IV forecast RV for the underlying currency of options for the 1-week horizon, and (c) IV forecast RV for the underlying currency of options for the 1-month horizon. Further, Chap. 5 provides empirical results based on the analysis (a) IV estimate currency options price for the within-week estimate horizon, (b) IV estimate currency options price for the 1-week estimate horizon, and (c) IV estimate currency options price for the 1-month estimate horizon. The overall results provide four critical insights. First, 3-month maturity IV does not contain vital information about the future volatility of the underlying currency and pricing currency options. Second, IV incorporates all information is not relevant to compute the value of currency options for less than a week estimate horizon. Third, IV of the closing period on Monday and Tuesday subsumes most of the essential information compared to other periods of a trading day and other days of a week to forecast volatility of the underlying currency and estimate the price of currency options. Fourth, the shorter (longer) maturity IV provides essential information to price currency options for the shorter (longer) estimate horizon.