Predicting nominal exchange rate movements using skewness information from options prices

Abstract

This paper uses a measure of the relative price of out-of-the-money (OTM) European put and call currency options to forecast daily movements in the dollar|euro exchange rate over the period of January 2002-June 2004. As these OTM options are pure bets on future movements of the exchange rate, their relative price contains information about the market's estimate of the relative probabilities of appreciation or depreciation of the euro over the life of the options. Forecasts that include the relative price of the OTM options offer significantly better out-of-sample predictions of tomorrow's exchange rate than either the simple random walk or an interest rate parity model. These results offer new insight into the puzzle of the day-to-day volatility of currency prices that should be driven by slow-moving macro fundamentals. Copyright © 2009 John Wiley & Sons, Ltd.