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Foreign currency options: An empirical analysis

Phung, T. K. F. (1998). Foreign currency options: An empirical analysis. (Unpublished Doctoral thesis, City, University of London)


The objective of this thesis is to study the pricing of foreign currency options by using transaction data. It is to investigate empirically the hypothesis of option markets efficiency on the Philadelphia Stock Exchange (PHLX) between August 1987 and October 1994 It uses daily trade-to-trade transaction for the studies on (1) European put-call parity, (2) American put-call pricing relationship, (3) the early- exercise premium of the American options, (4) the volatility smile and risk-neutral distribution of the American options, (5) models for predicting option prices with yesterday’s market volatility smile, and (6) the difference between volatility smiles on the over-the-counter (OTC) and PHLX markets.

The first three tests employ both non-transaction-cost and full-transaction-cost scenarios. The put-call party does not hold and the results provide evidence of arbitrage profit opportunities for investors (i.e., an investor might be able to earn risk-free profit). It is not possible to reject (with confidence) the hypothesis that PHLX currency option market is inefficient.

Deutsche Mark options are the most heavily traded options on the PHLX and they have therefore been used for sections (4) to (6). The fourth test confirms that the volatility smiles of calls and puts are asymmetrical, both calls and puts are skewed from the right to the left. The smile has an average positive (+1.2%) volatility skewness. The calls also have higher volatility than the puts in general. However, the OTC options in section (6) give a different result. The OTC and exchange markets have different volatility smiles and the OTC options’ volatility smile is negatively skewed.

Although the observed options’ volatilities have a smile, the predicting of tomorrow’s option prices in the section (5) with today’s market volatility smile gives larger errors than assuming no smile at all. The PHLX options in section (6) have an irregular wave-shaped volatility smile across strike prices and observed period. It reflects that prediction of option’s volatility required a more powerful deterministic volatility function. In section (6), PHLX options have higher volatility than OTC options. Moreover, both PHLX and OTC markets have different volatility skewness, it allows investors with low transaction costs to obtain risk-free arbitrages.

In summary, the six tests have showed that the options' markets are not perfectly efficient.

Publication Type: Thesis (Doctoral)
Subjects: H Social Sciences > HG Finance
Departments: Bayes Business School > Bayes Business School Doctoral Theses
Bayes Business School > Finance
Doctoral Theses
[thumbnail of Phung thesis 1998 PDF-A.pdf]
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