Kiel Working Papers, Kiel Institute for World Economics
No 970:
Noise Traders'Trigger Rates, FX Options, and Smiles
Christian Pierdzioch
Abstract: A contingent claims valuation model which allows to
highlight the implications of program trading in spot markets for the
pricing of European-style foreign currency options and for the volatility
strike structure implicit in these contracts is devoloped. The curvature of
the volatility strike structure is explained by focusing attention on the
expected aggregate net volume and direction of standing orders executed
when the exchange rate reaches certain implicit price barriers triggering
program traders to reallocate financial wealth. The valuation framework
allows to endogenously reproduce the characteristic convex shape of
volatility strike structures documented in the empirical literature. A
volatility-based test for implicit price barriers in foreign exchange
markets is employed to examine whether empirical evidence supports the
barriers hypothesis of the volatility strike structure proposed in the
paper.
Keywords: Foreign Currency Options, Volatility Smile, Noise Trading, Implicit Price Barriers, GARCH model; (follow links to similar papers)
JEL-Codes: F31; G13; (follow links to similar papers)
53 pages, March 2000
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