Volatility models of currency futures in developed and emerging markets

This paper examines volatility models of currency futures contracts for three developed markets and two emerging markets. For each contract, standard models of the Unbiased Expectations Hypothesis (UEH) and Cost-of-Carry hypothesis (COC) are extended to derive volatility models corresponding to each of the two standard approaches. Each volatility model is formulated as a system of individual equations for the conditional variances of futures returns, spot returns and the domestic risk-free interest rate. The empirical results suggest that the conditional volatility of futures return for emerging markets is significant in explaining the conditional volatility of returns in the underlying spot market. For developed markets, however, the conditional volatility of the spot returns is significant in explaining the conditional volatility of futures returns. Moreover, it is found that the domestic risk-free interest rate has little impact on the conditional variances of the futures, spot and domestic risk-free interest rates. Volatility System. 3 1. Introduction Over the last 25 years, financial innovation and competitive pressures have forced massive changes on the structure and institutions of the foreign exchange market. The Bank for International Settlements surveys [1] estimate that the total daily worldwide foreign exchange trading volume in 1998 alone was $1.5 trillion per day, or nearly $400 trillion per year. Trading volume on the foreign exchange markets is clearly massive. By comparison, only $58.8 billion in equities was traded on the busiest day in the history of the New York Stock Exchange [9], on 19 April 1999. The volatility in these markets became apparent after the devaluation of the pound sterling in November 1967, when a series of international financial crisis ensued until the Smithsonian agreement in 1971. Consequently, this led to the introduction of trading in foreign currency futures on the International Monetary Market