A proposed solution for the chicken-egg dilemma in pricing currency options

Hoque, Ariful and Krishnamurti, Chandrasekhar (2013) A proposed solution for the chicken-egg dilemma in pricing currency options. Australasian Accounting Business and Finance Journal , 7 (2). pp. 71-86. ISSN 1834-2000

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The implied volatility (IV) estimation process suffers from an obvious chicken-egg dilemma: obtaining an unbiased IV requires the options to be priced correctly and calculating an accurate option price (OP) requires an unbiased IV. We address this critical issue in two steps. First, the Granger causality test is employed, which confirms the chicken-and-egg problem in the IV computing process. Secondly, the concept of 'moneyness volatility (MV)'is introduced as an alternative to IV. MV is modelled based on an option's moneyness (OM)during the life of the option's contract. The F-test, Granger-Newbold test and Diebold-Mariano test results consistently show that MV outperforms IV in estimating the exchange rate volatility for pricing options. Further, these series of tests across six major currency options substantiate the validity as well as the reliability of the results. We posit that MV offers a unique solution for pricing currency options accurately.

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Item Type: Article (Commonwealth Reporting Category C)
Refereed: Yes
Item Status: Live Archive
Additional Information: © 2013 Australasian Accounting Business and Finance Journal and Authors. This publication is copyright. It may be reproduced in whole or in part for the purposes of study, research, or review, but is subject to the inclusion of an acknowledgment of the source.
Faculty / Department / School: Historic - Faculty of Business and Law - School of Accounting, Economics and Finance
Date Deposited: 17 Feb 2014 09:17
Last Modified: 09 Mar 2015 04:33
Uncontrolled Keywords: currency options pricing; implied volatility; moneyness volatility; Granger causality test; Granger-Newbold
Fields of Research : 15 Commerce, Management, Tourism and Services > 1502 Banking, Finance and Investment > 150205 Investment and Risk Management
14 Economics > 1401 Economic Theory > 140102 Macroeconomic Theory
14 Economics > 1402 Applied Economics > 140212 Macroeconomics (incl. Monetary and Fiscal Theory)
Socio-Economic Objective: B Economic Development > 91 Economic Framework > 9101 Macroeconomics > 910104 Exchange Rates
Identification Number or DOI: doi:10.14453/aabfj.v7i2.6
URI: http://eprints.usq.edu.au/id/eprint/24800

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