Implied volatility dynamics in the foreign exchange markets

The purpose of this study is to examine the dynamics of implied volatilities derived from the major currency options on futures. Several studies have examined the properties of implied volatilities in the equity and interest markets. However, very little is known about the dynamics of implied volatilities derived from the currency options markets, which is the subject of this paper. The results show that participants in the currency market tend to expect higher future volatility when the currency market fluctuates in a large scale regardless of the direction, implying that uncertainty, as measured by implied volatility, would be higher when movements of exchange rates are large. We also provide evidence that in the foreign exchange markets, the traders' trading pattern, or the private information, in addition to the public information, also drive the intraweek implied volatility patterns. Finally, we document that it would be difficult to earn abnormal trading profits with portfolios based on the observed patterns of implied volatilities, and conclude that the foreign exchange options on futures market is efficient in this sense. (C) 2003 Elsevier Science Ltd. All rights reserved.