Testing the Expectations Hypothesis on the Term Structure of Volatilities in Foreign Exchange Options




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    • Campa is from the Stern School of Business, New York University. Chang is from the Stern School of Business and Wharton School, University of Pennsylvania. For helpful comments, we would like to thank David Bates, John Campbell, Bernard Dumas, Charles Himmelberg, two referees, René Stulz (the editor), and seminar participants at the Wharton Macro and Micro Lunch Workshops, the London School of Economics, and the French Finance Association 1993 Meetings. We would also like to thank the following individuals for invaluable information about market behavior: Richard Holmes of Citibank, Philip Weisberg of JP Morgan, Steve Geovanis of Merrill Lynch, Luke Ding and Terence Tsang of National Westminster Bank, Jeffrey Mehan of Tradition Financial Services, and Sykes Wilford. Any remaining errors are our own.


This article tests the expectations hypothesis in the term structure of volatilities in foreign exchange options. In particular, it addresses whether long-dated volatility quotes are consistent with expected future short-dated volatility quotes, assuming rational expectations. For options observed daily from December 1, 1989 to August 31, 1992 on dollar exchange rates against the pound, mark, yen, and Swiss franc, we are unable to reject the expectations hypothesis in the great majority of cases. The current spread between long- and short-dated volatility rates proves to be a significant predictor of the direction of future short-dated rates.