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Pricing Currency Options in Tranquil Markets: Modelling Volatility Frowns

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  • G.C. Lim
  • G.M. Martin
  • V.L. Martin

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.

Suggested Citation

  • G.C. Lim & G.M. Martin & V.L. Martin, 2002. "Pricing Currency Options in Tranquil Markets: Modelling Volatility Frowns," Monash Econometrics and Business Statistics Working Papers 4/02, Monash University, Department of Econometrics and Business Statistics.
    • Handle: RePEc:msh:ebswps:2002-4
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    File URL: http://www.buseco.monash.edu.au/ebs/pubs/wpapers/2002/wp4-02.pdf
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    Option pricing; volatility frowns; thin-tails; generalized Student t.;
    All these keywords.

    JEL classification:

    • C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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