Does currency smirk predict foreign exchange return?

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This study examines the predictive power of implied volatility smirk to forecast foreign exchange (FX) return. The volatility smirk contains critical information, especially when the market experiences negative news. The Australian dollar, Canadian dollar, Swiss franc, Euro, and British pound options traded in the opening, midday and closing periods of the trading day are selected to estimate the currency smirk. Research results reveal that the currency smirk outperforms in forecasting FX returns. In addition, the steeper slope in the middle of the trading day suggests that the predictive power of currency smirk in the midday period is higher compared to the opening and closing periods. However, currency smirks’ predictability lasts for a short period, as the FX market is highly adept at incorporating the vital information embedded in the currency smirk. These findings imply that the currency smirk is distinctive for forecasting very short-term FX fluctuations, and the day- or overnight FX traders can use its uniqueness to profit from quick price swings in the 24-hour global FX market.

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    • Figure 1. Opening period OTM put implied volatility (blue color), ATM call implied volatility (red color) and volatility smirk (green color)
    • Figure 2. Midday period OTM put implied volatility (blue color), ATM call implied volatility (red color) and volatility smirk (green color)
    • Figure 3. Closing period OTM put implied volatility (blue color), ATM call implied volatility (red color) and volatility smirk (green color)
    • Figure 4. Currency smirks’ skewness comparison for opening period (blue color), midday period (red color) and closing period (green color)
    • Table 1. Currency options market efficiency analysis
    • Table 2. Descriptive analysis of the currency smirk
    • Table 3. Currency smirks’ information content analysis
    • Table 4. Currency smirks’ predictive power analysis
    • Conceptualization
      Ariful Hoque, Kamrul Hassan
    • Investigation
      Ariful Hoque
    • Methodology
      Ariful Hoque
    • Project administration
      Ariful Hoque
    • Supervision
      Ariful Hoque, Kamrul Hassan
    • Writing – original draft
      Ariful Hoque
    • Data curation
      Thi Ngoc Quynh Le
    • Formal Analysis
      Thi Ngoc Quynh Le
    • Software
      Thi Ngoc Quynh Le
    • Writing – review & editing
      Thi Ngoc Quynh Le, Kamrul Hassan
    • Resources
      Kamrul Hassan