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Journal of Financial Econometrics Advance Access originally published online on August 5, 2005
Journal of Financial Econometrics 2005 3(4):578-605; doi:10.1093/jjfinec/nbi021
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© The Author 2005. Published by Oxford University Press. All rights reserved. For permissions, please e-mail: journals.permissions@oupjournals.org.

The Accuracy of Density Forecasts from Foreign Exchange Options

Peter Christoffersen
     McGill University, CIRANO, and CIREQ

Stefano Mazzotta
     McGill University

Address correspondence to Peter Christoffersen, McGill University, Faculty of Management, 1001 Sherbrooke West, Montreal, PQ, Canada H3A 1G5, or e-mail: peter.christoffersen{at}mcgill.ca.

Financial decision makers often consider the information in currency option valuations when making assessments about future exchange rates. The purpose of this article is to systematically assess the quality of option-based volatility and density forecasts. We use a unique dataset consisting of more than 10 years of daily data on over-the-counter (OTC) currency option prices. We find that the OTC implied volatilities provide largely unbiased and fairly accurate forecasts of one-month- and three-month-ahead realized volatility. Furthermore, we find that the one-month option implied density forecasts are well calibrated for the center of the distribution, but we find evidence of misspecification in the tail density forecasts.

KEYWORDS: density, forecasting, FX, interval, volatility

Received April 1, 2004; revised March 2, 2005; accepted June 13, 2005


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