HOW DOES THE VOLATILITY RISK PREMIUM AFFECT THE INFORMATIONAL CONTENT OF CURRENCY OPTIONS

Interpretating probability density functions (PDFs) extracted from currency options data is ambiguous because PDFs combine risk neutral market views regarding the likelihood of particular exchange rate outcomes with investors ’ preferences towards risk. In order to disentangle the two effects, market expectations derived for option prices need to adjusted for the time-varying volatility risk premium that compensates risk averse option writers. Assuming rational expectations this risk premium can be extracted ex-post. The implied volatility bid-ask spread and volatility of implied volatility are considered here as proxies for the risk premium to enable the ex-ante adjustment of risk-neutral exchange rate expectations for risk preferences. The method is applied to demonstrate the impact of this adjustment on exchange rate expectations around Hong Kong SAR’s equity market intervention in 1998. The risk premium explains part of the bias found in existing empirical studies of the predictability of future realized volatility by implied volatility.