The Forecasting Ability of Correlations Implied in Foreign Exchange Options

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This paper evaluates the forecasting accuracy of correlation derived from implied volatilities in dollar-mark, dollar-yen, and mark-yen options from January 1989 to May 1995. As a forecast of realized correlation between the dollar-mark and dollar-yen, implied correlation is compared against three alternative forecasts based on time series data: historical correlation, RiskMetrics' exponentially weighted moving average correlation, and correlation estimated using a bivariate GARCH (1,1) model. At the one-month and three-month forecast horizons, we find that implied correlation outperforms, often significantly, these alternative forecasts. In combinations, implied correlation always incrementally improves the performance of other forecasts, but not the converse; in certain cases historically based forecasts contribute no incremental information to implied forecasts. The superiority of the implied correlation forecast holds even when forecast errors are weighted by realized variances, reflecting correlation's contribution to the dollar variance of a multicurrency portfolio.

Published:

• 2 (1995): 529- ,
• Journal of International Money and Finance, Vol. 17, no. 5 (October 1998): 855-880. Published as "Testing the Expectations Hypothesis on the Term Structure of Volatilities in Foreign Exchange Options", Journal of Finance, Vol. 50, no.

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