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Pricing currency options with Intra-Daily implied volatility

Hoque, A. and Kalev, P.S. (2015) Pricing currency options with Intra-Daily implied volatility. Australasian Accounting, Business and Finance Journal, 9 (1). pp. 43-56.

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Abstract

This paper introduces the intra-daily implied volatility (IDIV), a new volatility measure to price currency option accurately. The IDIV is developed based on the implied volatility estimated on equally spaced intradaily intervals. This model captures the intra-daily level aggregate information related to foreign exchange (FX) behavior, which changes every five minutes. The implied volatility (IV) and realized volatility (RV) are widely accepted as good estimates of daily and intra-daily price volatility, respectively. Therefore, using the options pricing framework, we assess the capability of IDIV against IV and RV in pricing foreign currency options. A comparison of out-of-sample forecasts under both the F-test and Diebold-Mariano test reveals that the IDIV outperforms both the IV and the RV in estimating one-day-ahead option prices. In other words, the IDIV estimation framework provides a more accurate and efficient volatility estimate for pricing currency options. The findings of this study indicate that the forward looking intra-daily information of IDIV is appropriate to price options correctly rather than forward looking daily and historical intra-daily information is obtained by the IV and RV, respectively.

Publication Type: Journal Article
Murdoch Affiliation: School of Management and Governance
Publisher: University of Wollongong
Copyright: © 2015 Australasian Accounting, Business and Finance Journal and authors
URI: http://researchrepository.murdoch.edu.au/id/eprint/26348
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