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Volatility and the cross-section of returns on FX options

Fullwood, J., James, J. and Marsh, I. W. ORCID: 0000-0002-0483-8658 (2020). Volatility and the cross-section of returns on FX options. Journal of Financial Economics,

Abstract

We study the cross-section of returns on FX options sorting currencies based on implied volatilities (IV). Long straddle positions in currencies with low (high) implied volatilities perform well (poorly). A long low IV-short high IV strategy produces large average returns after transactions costs. Total volatility matters rather than any component or transformation of volatility. The returns are distinct from those in the literature on foreign exchange returns or equity option returns and cannot be explained convincingly by standard risk factors. We argue cross-sectional differences in hedging demand combined with limits to arbitrage contribute to misspricing in FX options.

Publication Type: Article
Additional Information: © 2020. This manuscript version is made available under the CC-BY-NC-ND 4.0 license http://creativecommons.org/licenses/by-nc-nd/4.0/
Publisher Keywords: Options returns, implied volatility, straddles, foreign exchange
Subjects: H Social Sciences > HG Finance
Departments: Business School > Finance
Date Deposited: 29 Sep 2020 13:27
URI: https://openaccess.city.ac.uk/id/eprint/24959
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