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Foreign exchange option and returns based correlation forecasts: evaluation and two applications

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  • Castrén, Olli
  • Mazzotta, Stefano

Abstract

We compare option-implied correlation forecasts from a dataset consisting of over 10 years of daily data on over-the-counter (OTC) currency option prices to a set of return-based correlation measures and assess the relative quality of the correlation forecasts. We find that while the predictive power of implied correlation is not always superior to that of returns based correlations measures, it tends to provide the most consistent results across currencies. Predictions that use both implied and returns-based correlations generate the highest adjusted R2s, explaining up to 42 per cent of the realised correlations. We then apply the correlation forecasts to two policyrelevant topics, to produce scenario analyses for the euro effective exchange rate index, and to analyse the impact on cross-currency co-movement of interventions on the JPY/USD exchange rate. JEL Classification: F31, F37, G15

Suggested Citation

  • Castrén, Olli & Mazzotta, Stefano, 2005. "Foreign exchange option and returns based correlation forecasts: evaluation and two applications," Working Paper Series 447, European Central Bank.
    • Handle: RePEc:ecb:ecbwps:2005447
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    References listed on IDEAS

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    1. Tim Bollerslev & Hao Zhou, 2003. "Volatility puzzles: a unified framework for gauging return-volatility regressions," Finance and Economics Discussion Series 2003-40, Board of Governors of the Federal Reserve System (U.S.).
    2. Michael W. Brandt & Francis X. Diebold, 2006. "A No-Arbitrage Approach to Range-Based Estimation of Return Covariances and Correlations," The Journal of Business, University of Chicago Press, vol. 79(1), pages 61-74, January.
    3. Thimann, Christian & Buldorini, Luca & Makrydakis, Stelios, 2002. "The effective exchange rates of the euro," Occasional Paper Series 2, European Central Bank.
    4. Luca Buldorini & Stelios Makrydakis & Christian Thimann, 2002. "The effective exchange rates of the euro," Occasional Paper Series 02, European Central Bank.
    5. Blair, Bevan J. & Poon, Ser-Huang & Taylor, Stephen J., 2001. "Forecasting S&P 100 volatility: the incremental information content of implied volatilities and high-frequency index returns," Journal of Econometrics, Elsevier, vol. 105(1), pages 5-26, November.
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    Cited by:

    1. repec:cnb:ocpubv:as14 is not listed on IDEAS
    2. Daniel Stavárek, 2009. "Assessment of the exchange rate convergence in Euro-candidate countries," The AMFITEATRU ECONOMIC journal, Academy of Economic Studies - Bucharest, Romania, vol. 11(25), pages 159-180, February.
    3. Leonidas Tsiaras, 2010. "Dynamic Models of Exchange Rate Dependence Using Option Prices and Historical Returns," CREATES Research Papers 2010-35, Department of Economics and Business Economics, Aarhus University.
    4. repec:cnb:ocpubv:as17 is not listed on IDEAS
    5. Hassan, M. Kabir & Ngene, Geoffrey M. & Yu, Jung-Suk, 2015. "Credit default swaps and sovereign debt markets," Economic Systems, Elsevier, vol. 39(2), pages 240-252.
    6. Bisht Deepak & Laha, A. K., 2017. "Assessment of Density Forecast for Energy Commodities in Post-Financialization Era," IIMA Working Papers WP 2017-07-01, Indian Institute of Management Ahmedabad, Research and Publication Department.
    7. repec:cnb:ocpubv:as10 is not listed on IDEAS
    8. repec:cnb:ocpubv:as13 is not listed on IDEAS
    9. Kopaliani, R. & Denisov, N., 2023. "Composite option pricing and the volatility surface construction," Journal of the New Economic Association, New Economic Association, vol. 60(3), pages 27-48.
    10. repec:cnb:ocpubv:as16 is not listed on IDEAS
    11. repec:cnb:ocpubv:as12 is not listed on IDEAS
    12. repec:cnb:ocpubv:as15 is not listed on IDEAS

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    More about this item

    Keywords

    Correlation forecasts; currency options data; effective exchange rate;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F37 - International Economics - - International Finance - - - International Finance Forecasting and Simulation: Models and Applications
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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