The Term Structure of Volatility Implied by Foreign Exchange Options

Abstract

This paper illustrates regression and Kalman filtering methods for estimating the time-varying term structure of volatility expectations revealed by options prices. Short- and long-term expectations are estimated for four currencies using daily PHLX options prices from 1985 to 1989. Throughout this period, there were important differences between shortand long-term expectations. The slope of the term structure changed frequently and there were significant variations in long-term volatility expectations. The expectation estimates can be used to value OTC options, to improve hedging strategies, and to test the hypothesis that the options market overreacts.