Predicting Volatility in the Foreign Exchange Market

TLDR

Volatility implied in option prices is widely regarded as the best available forecast. The study examines the predictive power of implied standard deviations from CME options on foreign currency futures. The authors use simulations to test robustness, revealing that measurement errors and statistical issues can distort inferences. Statistical time‑series models are outperformed by ISDs, yet ISDs are biased, overly variable, and susceptible to distortion from measurement errors and statistical problems.

Abstract

ABSTRACT Measures of volatility implied in option prices are widely believed to be the best available volatility forecasts. In this article, we examine the information content and predictive power of implied standard deviations (ISDs) derived from Chicago Mercantile Exchange options on foreign currency futures. The article finds that statistical time‐series models, even when given the advantage of “ex post” parameter estimates, are outperformed by ISDs. ISDs, however, also appear to be biased volatility forecasts. Using simulations to investigate the robustness of these results, the article finds that measurement errors and statistical problems can substantially distort inferences. Even accounting for these, however, ISDs appear to be too variable relative to future volatility.