Dynamic models of exchange rate dependence using option prices and historical returns

Research output: Working paper

Abstract

Models for the conditional joint distribution of the U.S. Dollar/Japanese Yen and Euro/Japanese Yen exchange rates, from November 2001 until June 2007, are evaluated and compared. The conditional dependency is allowed to vary across time, as a function of either historical returns or a combination of past return data and option-implied dependence estimates. Using prices of currency options that are available in the public domain, risk-neutral dependency expectations are extracted through a copula repre- sentation of the bivariate risk-neutral density. For this purpose, we employ either the one-parameter \Normal" or a two-parameter \Gumbel Mixture" specification. The latter provides forward-looking information regarding the overall degree of covariation, as well as, the level and direction of asymmetric dependence. Specifications that include option-based measures in their information set are found to outperform, in-sample and out-of-sample, models that rely solely on historical returns.
Original languageEnglish
PublisherAarhus University
Number of pages45
Publication statusUnpublished - 12 Jan 2010

Publication series

NameCREATES Research Paper 2010-35

Fingerprint

Exchange rates
Option prices
Copula
Joint distribution
Currency options
Asymmetric dependence
Risk-neutral density

Keywords

  • exchange rates
  • options
  • forecasting
  • copula
  • implied correlation

Cite this

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Dynamic models of exchange rate dependence using option prices and historical returns. / Tsiaras, Leonidas.

Aarhus University, 2010. (CREATES Research Paper 2010-35).

Research output: Working paper

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AB - Models for the conditional joint distribution of the U.S. Dollar/Japanese Yen and Euro/Japanese Yen exchange rates, from November 2001 until June 2007, are evaluated and compared. The conditional dependency is allowed to vary across time, as a function of either historical returns or a combination of past return data and option-implied dependence estimates. Using prices of currency options that are available in the public domain, risk-neutral dependency expectations are extracted through a copula repre- sentation of the bivariate risk-neutral density. For this purpose, we employ either the one-parameter \Normal" or a two-parameter \Gumbel Mixture" specification. The latter provides forward-looking information regarding the overall degree of covariation, as well as, the level and direction of asymmetric dependence. Specifications that include option-based measures in their information set are found to outperform, in-sample and out-of-sample, models that rely solely on historical returns.

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Tsiaras L. Dynamic models of exchange rate dependence using option prices and historical returns. Aarhus University. 2010 Jan 12. (CREATES Research Paper 2010-35).