Is implied volatility sensitive to the choice of currency options maturity period?

Is implied volatility sensitive to the choice of currency options maturity period?

Implied volatility (IV) is widely used in pricing options because traders believe that IV is the best predictor of exchange rate volatility. The Philadelphia Stock Exchange offers a continuous series of strike price options that can expire on more than one maturity date. This leads to the question of whether IV is also sensitive to the choice of the options maturity period. To examine this question, this study first chooses two types of options based on the maturity period: (1) within-month-maturity options with expiration period ranges from one day to one month; and (2) next-month-maturity options with an expiration period varying from one month to two months. The IV for within-month-maturity options (WMIV) and next-month-maturity options (NMIV) are estimated. Second, the realized volatility (RV) over the remaining life of the options is constructed from the daily return of exchange rate volatility. The RV for the within-month-maturity options expiration period (WMRV) and the next-month-maturity options expiration period (NMRV) is computed. Finally, graphical and statistical approaches are employed to assess the ability of WMIV and NMIV to explain WMRV and NMRV, respectively. The test results argue that the options with two maturities provide the IV with different characteristics. The analysis also shows that NMIV is superior to WMIV for explaining exchange rate volatility. Therefore, we assert that IV is sensitive to the choice of options maturity period. This novel approach can be used to select the options maturity period for the best IV estimation outcome.

Copyright Taiwan Institute of Business Administration.