Dynamic Volatility Trading Strategies in the Currency Option Market

The conditional volatility of foreign exchange rates can be predicted using GARCH models or implied volatility extracted from currency options. This paper investigates whether these predictions are economically meaningful in trading strategies that are designed only to trade volatility risk. First, this article provides new evidence on the issue of information content of implied volatility and GARCH volatility in forecasting future variance. In an artificial world without transaction costs both delta-neutral and straddle trading stratgies lead to significant positive profits, regardless of which volatility prediction method is used. Specifically, the agent using the Implied Stochastic Volatility Regression method (ISVR) earns larger profits than the agent using the GARCH method. Second, it suggests that the currency options market is informationally efficient. After accounting for transaction costs, which are assumed to equal one percent of option prices, observed profits are not significantly differentfrom zero in most trading strategies. Finally, these strategies offered returns have higher Sharpe ratio and lower correlation with several major asset classes. Consequently, hedge funds and institutional investors who are seeking alternative “marketneutral” investment methods can use volatility trading to improvethe risk-return profile of their portfolio through diversification. Copyright Kluwer Academic Publishers 2000