Volatility, momentum, and time-varying skewness in foreign exchange returns

Johnson, T (2001) Volatility, momentum, and time-varying skewness in foreign exchange returns. Working Paper. London Business School IFA Working Paper.

Abstract

This paper tests a stochastic volatility model of exchange rates which links both the level of volatility and its instantaneous covariance with returns to pathwise properties of the currency. In particular, the model implies that the returnvolatility covariance behaves like a weighted average of recent returns, and hence switches signs according to the direction of trends in the data. This implies that the skewness of the finitehorizon return distribution likewise switches sign, leading to timevarying implied volatility "smiles " in options prices. The model is fit and assessed using Bayesian techniques. Some previously reported volatility results are accounted for by the fitted models. The predicted pattern of skewness dynamics accords well with that found in historical options prices.