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The Term Structure of Volatility Implied by Foreign Exchange Options

Published online by Cambridge University Press:  06 April 2009

Xinzhong Xu  and
Stephen J. Taylor
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Abstract

This paper illustrates regression and Kalman filtering methods for estimating the time-varying term structure of volatility expectations revealed by options prices. Short- and long-term expectations are estimated for four currencies using daily PHLX options prices from 1985 to 1989. Throughout this period, there were important differences between shortand long-term expectations. The slope of the term structure changed frequently and there were significant variations in long-term volatility expectations. The expectation estimates can be used to value OTC options, to improve hedging strategies, and to test the hypothesis that the options market overreacts.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 29 , Issue 1 , March 1994 , pp. 57 - 74
Copyright
Copyright © School of Business Administration, University of Washington 1994

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