The Dynamic Behavior of Foreign Exchange Rates with Stochastic Volatility and Jump Diffusion Models-Evidences from KRW/USD Spot and Option Markets

• Published in: Seonmul yeongu (Online) Vol. 19; no. 1; pp. 1 - 36
• Main Authors: In Seok Baek, Byung Jin Kang
• Format: Journal Article
• Language: English
• Published: Bingley Emerald Group Publishing Limited 28.02.2011
• Subjects: Derivatives; Foreign exchange rates; Volatility
• ISSN: 1229-988X; 2713-6647
• DOI: 10.1108/JDQS-01-2011-B0001

This paper assesses the empirical performances of the continuous-time models, including constant volatility (Black and Scholes, 1973), stochastic volatility (Heston, 1993), and stochastic volatility with jumps (Bates, 1996), in FX spot and option markets. To analyze the spot market, we used the EMM (Efficient Method of Moments) methods with daily KRW/USD spot exchange rates from November 1997 through July 2009. First, the empirical results find that the Bates model highly outperforms the other modelsin explaining the dynamic behavior of KRW/USD spot exchange rates. Second, we also find that the jump components carry out an important role in generating leptokurtic properties of KRW/USD spot exchange rates, on the other hand, stochastic volatilities perform a critical role in generating skewed properties of them. To analyze the option market, we examined the daily cross-sectional prices of the KRW/USD OTC options from January 2006 through March 2010. The empirical results from the option markets confirm that the Bates model clearly outperforms the other modelsin explaining the observed patterns of implied-volatility smile or smirk.