Overreactions in the Foreign Currency Options Market

• DOI: http://doi.org/10.1111/ajfs.12133
• Published date: 01 June 2016
• Date: 01 June 2016

Overreactions in the Foreign Currency

Options Market

JoongHo Han

Business School, Sungkyunkwan University

Byung Jin Kang

Department of Finance, Soongsil University

Ki Cheon Chang*

IT Division, Korea Development Bank

Suk Joon Byun

College of Business, Korea Advanced Institute of Science and Technology

Received 10 October 2015; Accepted 24 November 2015

Abstract

The seminal research by Stein (Journal of Finance 1989, 44, 1011) shows that long-term

options overreact to short-term volatility shocks. In contrast, recent studies show that such

irrational responses disappear when model-free implied volatilities are used. We extend this

literature by examining overreactions in the over-the-counter currency options market. Using

model-free implied volatility and by considering the estimated structural breaks around

recent financial crises, we find consistent evidence for volatility overreactions during non-cri-

sis periods but no conclusive evidence of such behavior during recent crises periods. Overall,

our findings suggest that it is crucial to consider structural changes when testing for overre-

actions in options markets.

Keywords Model-free implied volatility; Over-the-counter currency option; Overreaction;

Structural breaks; Volatility anomaly

JEL Classification: G13, G14, G15

1. Introduction

Stock market overreactions have been the subject of intense investigations in finance

and economics (Schwert, 2003). Some studies extend the literature to the options

market. In particular, the seminal study by Stein (1989) documents that the long-

*Corresponding author: Ki Cheon Chang, Korea Development Bank, 14 Eunhaeng-ro,

Yeongdeungpo-gu, Seoul 07242, Korea. Tel:+82-2-787-7137, Fax: 82-2-787-0691, email:

kicheon.chang@gmail.com.

Asia-Pacific Journal of Financial Studies (2016) 45, 380–404 doi:10.1111/ajfs.12133

380 ©2016 Korean Securities Association

term implied variance of stock index options tends to overreact to volatility shocks.

Poteshman (2001) further documents the existence of both short-term underreac-

tions and long-term overreactions in the trading of short-term maturity index

options. However, recent studies challenge these findings by showing that volatility

overreactions become insignificant when more generalized implied volatility specifi-

cations are considered (Jiang and Tian, 2010).

This paper attempts to extend the literature by investigating the anomalous pat-

terns of implied volatility in over-the-counter (OTC) currency options markets.

Despite the lack of conclusive evidence for volatility anomalies in stock index

options markets, few studies reexamine overreactions and underreactions in alterna-

tive options markets.

1

Although the foreign exchange (FX) market is one of the lar-

gest financial markets, the literature is yet to investigate implied volatility behavior

in currency options markets. The average daily trading volume of the FX market in

2011 was US$4.7 trillion (US$1.57 trillion spot transactions and US$3.13 trillion

derivatives transactions), which is 70 times greater than the average daily trading

volume on the New York Stock Exchange (NYSE; Saunders and Cornett, 2014).

Hence, FX options markets clearly provide another important avenue for examining

option market anomalies.

Over-the-counter currency option markets differ from listed stock index options

in two ways. First, individual investors tend to more actively trade liste d options

than OTC options, suggesting that OTC currency options are less likely to experi-

ence volatility anomalies than stock index options. However, Lemmon and Ni

(2008) show that individual investors are inactive in the S&P 500 index options

market: from 1990 to 2001, only 2.4% of the total non-market-maker trading vol-

ume came from discount brokerage customers, whereas 27.4% came from propri-

etary trading by institutional traders. This finding suggests that both markets differ

less than commonly believed in terms of investor sophistication.

Second, existing studies show that FX rates experience regime shifts (Engel and

Hamilton, 1990; Bekaert and Hodrick, 1993; Engel and Hakkio, 1996; Bollen et al.,

2000). Carr and Wu (2007) confirm that the conditional risk-neutral distribution of

currency returns usually exhibits strong asymmetry that varies significantly over time

and has a skewness that often changes signs. However, they find that the risk-neutral

skewness extracted from stock index options remains negative for most periods,

although it also varies over time. Moreover, a recent study by Cho et al. (2016) shows

that the link between equity and currency markets intensifies during market down-

turns, suggesting a potential structural shift during the recent financial crisis. During

the recent financial crisis, if “flight-to-quality” had led to hedging demands dominat-

ing currency market transactions, the model by Goldstein et al. (2014) suggests that

currency option trading may have become less sensitive to the arrival of new infor-

mation as speculative trading became relatively scarce. In contrast, a stark increase in

risk averseness during the recent crisis may have induced severe overreaction patterns

1

Campa and Chang (1995) is an exception.

Overreactions in the Foreign Currency Options

©2016 Korean Securities Association 381