Can OTC Currency Option Volatility Smile Predict Currency Future Returns?

Lots of previous studies show the volatility smile in option markets has significant predictive power for future stock returns. In this paper we want to exam the predictability of measure of volatility smile for future currency returns. Different from previous studies, we use OTC option data instead of exchange market data.

By regressing future currency returns on the measures of volatility smile, we find the measures of volatility smile for exchange rates related to Yen have significant predictability to future currency returns. The predictability persists up to 20 weeks. However, the two Long-Short strategies cannot get extra returns compared with the Buy-and-Hold strategy.