Modelling Exchange Rate Return Behavior for Pricing Currency Options

Since the currency options derive their values from the underlying foreign currencies, their pricing are closely related to the expected volatility of the underlying exchange rates. This study focuses oil modeling the time varying nature of the underlying exchange rate volatility. It explores the possibility of using an implied volatility model (IVM) and a GARCH (1,1)-bascd volatility model (GVM) to generate inputs for Black-Schole (1973) options pricing formula. Since in-sample tests provide a mixed result, the ability of IVM and GVM is not distinguishable to describe the unobservable underlying exchange rate return behavior. The out-of-sample tests results strongly Suggest that IVM is more capable to capture underlying exchange rate return behavior to forecast options prices with higher accuracy.