Volume 14 | Issue 2 | Article 1
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The Implied Exchange Rates Derived from Option Premiums: A Test of the Currency Option Boundary
This paper proposes a method based on currency option boundaries to investigate the informational content in option markets. This approach not only avoids non-synchronous trading and option model misspecification problems, but also incorporates early exercise effects and market frictions into the derivation of implied prices. The test results suggest that implied exchange rates derived from option boundaries contain information about future exchange rate changes. Particularly, bid and ask quotes in option markets reflect market makers' information about future price movements. Liquidity also affects the information content in option markets. However, option boundary violations do not contain predictability and, thus, tend to be driven by noise trading. In a trading simulation, we find that the predictability yields the trading profits that are substantially higher than those from random walk or buy-and-hold trading strategies.
