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Forecasting Foreign Exchange Volatility: Why Is Implied Volatility Biased and Inefficient? And Does It Matter?

Research has consistently found that implied volatility is a conditionally biased predictor of realized volatility across asset markets. This paper evaluates explanations for this bias in the market for options on foreign exchange futures. No solution considered–including a model of priced volatility risk–explains the conditional bias found in implied volatility. Further, while implied volatility fails to subsume econometric forecasts in encompassing regressions, these forecasts do not significantly improve delta-hedging performance. Thus this paper deepens the implied volatility puzzle by rejecting popular explanations for forecast bias while demonstrating that statistical measures of bias and informational inefficiency should be treated with circumspection.

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