The Forecast Ability of Option-implied Densities from Emerging Markets Currencies

Authors

DOI:

https://doi.org/10.12660/bre.v36n12016.45406

Keywords:

Relative Risk Version, Risk-Neutral Density, Exchange Rates

Abstract

This paper empirically evaluates Risk-Neutral Densities (RND) and Real-World Densities (RWD) as predictors of emerging markets currencies. The dataset consists of volatility surfaces from 11 emerging market currencies, with approximately six years of daily data, using options with one-month expiration. Therefore, there is a strong overlapping in data, which is tackled with specific econometric techniques. Results of the out-of-sample assessment show that both RND and RWD underweight the tails of the actual distribution. This is probably due to the lack of options with extreme strikes. Although the RWDs perform better than RND in terms of Kolmogorov distance, they still have problems in fitting the tails of actual data. Thus, the risk-aversion adjustment may improve the forecast ability, but it does not solve the tails misfitting.

Author Biography

José Renato Haas Ornelas, Banco Central do Brasil

Analyst, Research Department

Published

10-03-2016

Issue

Section

Articles