How Important is the Term Structure in Implied Volatility Surface Modeling? Evidence from Foreign Exchange Options

Journal of International Money and Finance, Vol. 30, No. 4, pp. 623-640

40 Pages Posted: 16 Feb 2009 Last revised: 22 Jan 2013

See all articles by George Chalamandaris

George Chalamandaris

Athens University of Economics and Business - Department of Accounting and Finance

Andrianos E. Tsekrekos

Athens University of Economics and Business - Department of Accounting and Finance

Date Written: January 18, 2011

Abstract

We claim that previously proposed parametric specifications that linearly approximate the term structure of the implied volatility surface (IVS) in option prices fail to capture important information regarding the expectations of market participants. This paper proposes a parametric specification for describing the IVS that allows flexible modeling of the term structure through a Nelson and Siegel (1987) factorization, recently proposed by Diebold and Li (2006) in the context of yield curve modeling. The specification is tested on implied volatilities from the over–the–counter foreign exchange options market, where contracts with long expiries are actively traded and thus the term structure dimension of the surface should be very important. We first show that the proposed volatility specification can consistently and remarkably improve our ability to describe the surface on any given day. We then establish the economic relevance of the incremental information captured by our proposed specification by showing that it can produce more accurate forecasts of implied volatility that can support long–term profitable trading strategies in the absence of transaction costs.

Keywords: Exchange rates, Term structure, Implied volatility surfaces, Volatility functions, Forecasting, Foreign exchange options

JEL Classification: C53, G13, F37

Suggested Citation

Chalamandaris, George and Tsekrekos, Andrianos E., How Important is the Term Structure in Implied Volatility Surface Modeling? Evidence from Foreign Exchange Options (January 18, 2011). Journal of International Money and Finance, Vol. 30, No. 4, pp. 623-640, Available at SSRN: https://ssrn.com/abstract=1344180

George Chalamandaris (Contact Author)

Athens University of Economics and Business - Department of Accounting and Finance ( email )

76 Patission Street
GR-104 34 Athens
Greece

Andrianos E. Tsekrekos

Athens University of Economics and Business - Department of Accounting and Finance ( email )

76 Patission Street
GR-104 34 Athens
Greece

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
246
Abstract Views
1,114
rank
149,527
PlumX Metrics