Abstract
M.Comm.
The fundamental objective of this paper is to effectively analise and forecast currency option volatility in the South African derivative market. The study of Dollar/Rand volatility is based in the domain of quantitative and international economics. It focuses on the monetary aspect of international finance, where currency volatility is of critical significance in the hedging of open currency option positions used in investment strategies as well as in active currency risk management. Topics covered in this study include firstly a theoretical discussion of option pricing and volatility to provide the necessary financial and statistical background: Advanced volatility issues are secondly addressed to define the volatility matrix and to explain the appearance of volatility smiles and cones as well as the characteristics of the time structure of volatility. The use of volatility as an important risk management tool is also depicted. Various time-series techniques such as the Box Jenkins methodology and decomposition of Dollar/Rand historical and implied volatility are assessed and used to forecast volatility. Univariate and multivariate regression analysis is in addition described and used to find the best estimate for subsequent Dollar/Rand volatility. Finally, the paper is concluded by an analysis of time varying stochastic volatility models such as the models for autoregressive conditional heteroscedasticity. The techniques apply a regression on the variance and include a function to allow for the asymmetric nature of movements in Dollar/Rand volatility. Up to date, no formal in-depth academical research on high frequency currency volatility has been conducted in the South African derivative market. It is therefor crucial to research the unique characteristics of Dollar/Rand option volatility. If the study concludes that Dollar/Rand volatility is predictable, it will have important implications for currency option pricing and portfolio management. Investors seeking to avoid risk, may choose to adjust their portfolios by reducing their commitments to assets whose volatilities are predicted to increase, or by using dynamic diversification approaches to hedge predicted volatility increases. This is particularly true of currency derivative markets where the volatility of the underlying asset has a profound effect on the value of the derivative.