Cause-and-effect between implied volatility and options price

Abstract

Implied volatility is widely believed to be the best underlying exchange rate volatility forecast for pricing currency options. To measure unbiased implied volatility requires accurate options price. Unbiased implied volatility is also needed for pricing options correctly. Consequently, an interesting question is raised, is it options price that causes the implied volatility or is it the implied volatility that causes options price? This study employs the Granger causality test to address this critical issue for six major currency options are traded in Philadelphia Stock Exchange. The test results identify the bilateral Granger causality between implied volatility and options price, which distorts options pricing accuracy. We, therefore, cannot conclude that the implied volatility is the best choice for pricing currency options.