Spot and Forward Volatility in Foreign Exchange
Posted: 16 Feb 2009 Last revised: 2 May 2012
Date Written: August 10, 2009
This paper investigates the empirical relation between spot and forward implied volatility in foreign exchange. We formulate and test the forward volatility unbiasedness hypothesis, which is the volatility analogue to the extensively researched hypothesis of unbiasedness in forward exchange rates. Using a new data set of spot implied volatility quoted on over-the-counter currency options, we compute the forward implied volatility that corresponds to the forward contract on future spot implied volatility known as a forward volatility agreement. We find statistically significant evidence that forward implied volatility is a systematically biased predictor that overestimates future spot implied volatility. The bias in forward volatility generates high economic value to an investor exploiting predictability in the returns to volatility speculation and indicates the presence of predictable volatility term premiums in foreign exchange.
Keywords: Implied Volatility, Foreign Exchange, Forward Volatility Agreement, Unbiasedness, Volatility Speculation
JEL Classification: F31, F37, G10, G11
Suggested Citation: Suggested Citation