The smile of currency derivatives – PCA modelling of the FX effect
(2016) NEKN02 20161Department of Economics
- Abstract
- This paper investigates the non-flat volatility surface of foreign exchange options, a so-called volatility smile. Foreign exchange options are especially interesting due their liquidity and frequency in risk management. To propose a non-complex model of the determinants of variation in the smile, a principal component approach is suggested. As this approach allows for explanation of the development of the smile with a streamlined three-factor model, this suggests an easy interpreted model with application in risk management. To evade problems with noise in data, this paper proposes to apply the principal component analysis on fixed-delta volatility deviations from at-the-money volatility. Furthermore the paper seeks to capture potential... (More)
- This paper investigates the non-flat volatility surface of foreign exchange options, a so-called volatility smile. Foreign exchange options are especially interesting due their liquidity and frequency in risk management. To propose a non-complex model of the determinants of variation in the smile, a principal component approach is suggested. As this approach allows for explanation of the development of the smile with a streamlined three-factor model, this suggests an easy interpreted model with application in risk management. To evade problems with noise in data, this paper proposes to apply the principal component analysis on fixed-delta volatility deviations from at-the-money volatility. Furthermore the paper seeks to capture potential links between current market condition and movement in the smile. The results show that foreign exchange volatility dynamics are dependent upon current market conditions. (Less)
Please use this url to cite or link to this publication:
http://lup.lub.lu.se/student-papers/record/8877770
- author
- Nielsen, Ola LU
- supervisor
- organization
- course
- NEKN02 20161
- year
- 2016
- type
- H1 - Master's Degree (One Year)
- subject
- keywords
- foreign exchange, option, risk management, implied volatility, volatility smile, principal components
- language
- English
- id
- 8877770
- date added to LUP
- 2016-06-13 14:08:16
- date last changed
- 2016-06-13 14:08:16
@misc{8877770, abstract = {{This paper investigates the non-flat volatility surface of foreign exchange options, a so-called volatility smile. Foreign exchange options are especially interesting due their liquidity and frequency in risk management. To propose a non-complex model of the determinants of variation in the smile, a principal component approach is suggested. As this approach allows for explanation of the development of the smile with a streamlined three-factor model, this suggests an easy interpreted model with application in risk management. To evade problems with noise in data, this paper proposes to apply the principal component analysis on fixed-delta volatility deviations from at-the-money volatility. Furthermore the paper seeks to capture potential links between current market condition and movement in the smile. The results show that foreign exchange volatility dynamics are dependent upon current market conditions.}}, author = {{Nielsen, Ola}}, language = {{eng}}, note = {{Student Paper}}, title = {{The smile of currency derivatives – PCA modelling of the FX effect}}, year = {{2016}}, }