The quality of volatility traded on the over-the-counter currency market: A multiple horizons study

Abstract

Previous studies of the quality of market-forecasted volatility have used the volatility that is impliedby exchange-traded option prices. The use of implied volatility in estimating the market view of futurevolatility has suffered from variable measurement errors, such as the non-synchronization of option andunderlying asset prices, the expiration-day effect, and the volatility smile effect. This study circumventsthese problems by using the quoted implied volatility from the over-the-counter (OTC)currency option market, in which traders quote prices in terms of volatility. Furthermore, the OTC currencyoptions have daily quotes for standard maturities, which allows the study to look at the market's ability toforecast future volatility for different horizons. The study finds that quoted implied volatility subsumes theinformation content of historically based forecasts at shorter horizons, and the former is as good as the latterat longer horizons. These results are consistent with the argument that measurement errors have a substantialeffect on the implied volatility estimator and the quality of the inferences that are based on it. © 2003Wiley Periodicals, Inc. Jrl Fut Mark 23:261–285, 2003