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The smile of currency derivatives – PCA modelling of the FX effect

Nielsen, Ola LU (2016) NEKN02 20161
Department 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)
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author
Nielsen, Ola LU
supervisor
organization
course
NEKN02 20161
year
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},
  keyword      = {foreign exchange,option,risk management,implied volatility,volatility smile,principal components},
  language     = {eng},
  note         = {Student Paper},
  title        = {The smile of currency derivatives – PCA modelling of the FX effect},
  year         = {2016},
}