THE RISK PREMIUM OF VOLATILITY IMPLICIT IN CURRENCY OPTIONS

This article provides an empirical investigation of the risk-neutral v ariance process and the market price of variance risk implied in the f oreign-currency options market. There are three principal contribution s. First, the parameters of Heston's mean-reverting square-root stocha stic volatility model are estimated using dollar/mark option prices fr om 1987 to 1992. Second, it is shown that these implied parameters can be combined with historical moments of the dollar/mark exchange rate to deduce an estimate of the market price of variance risk. These esti mates are found to be nonzero, time varying, and of sufficient magnitu de to imply that the compensation for variance risk is a significant c omponent of the risk premia in the currency market. Finally, the out-o f-sample test suggests that the historical variance and the Hull and W hite implied variance contain no more information than that imbedded i n the Heston implied variance.