The Informational Content of Over-the-Counter Currency Options

Policy makers and market participants often consider the forward-looking information in currency option valuations when making assessments about future developments in foreign exchange rates. Option implied volatilities can be used as forecasts of realized volatility and interval and density forecasts can be extracted from strangles and risk-reversals. The purpose of this paper is to assess the quality of such volatility, interval and density forecasts. We analyze option-based forecasts from a unique dataset consisting of over 10 years of daily data on over-the-counter (OTC) currency option prices. We find that the OTC implied volatilities explain a much larger share of the variation in realized volatility than has been found previously in studies relying on market-traded options. We also find that wide-range interval forecasts are often misspecified whereas narrow-range interval forecasts are well specified. Finally, we find that the option-based density forecasts are rejected in general. Graphical inspection of the density forecasts suggests that while the sources of rejections vary from currency to currency misspecification of the distribution tails is a common source of error.
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