Working Paper: CEPR ID: DP7893
Authors: Pasquale Della Corte; Lucio Sarno; Ilias Tsiakas
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: Foreign Exchange; Forward Volatility Agreement; Implied Volatility; Unbiasedness; Volatility Speculation
JEL Codes: F31; F37; G10; G11
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| forward implied volatility (G17) | future spot implied volatility (G17) |
| forward implied volatility (G17) | overestimated future spot implied volatility (G17) |
| forward volatility bias (G17) | excess returns in volatility speculation strategies (G17) |