Testing the Expectations Hypothesis on the Term Structure of Volatilities in Foreign Exchange Options
JOURNAL OF FINANCE, Vol 50 No 2, June 1995
Posted: 17 Apr 1995
This paper tests the expectations hypothesis in the term structure of volatilities in foreign exchange options. In particular, it addresses whether long-dated volatility quotes are consistent with expected future short-dated volatility quotes, assuming rational expectations. For options observed daily from December 1, 1989 to August 31, 1992 on dollar exchange rates against the pound, mark, yen, and Swiss franc, we are unable to reject the expectations hypothesis in the great majority of cases. The current spread between long- and short-dated volatility rates proves to be a significant predictor of the direction of future short-dated rates.
JEL Classification: F31
Suggested Citation: Suggested Citation