THE FORECASTING ABILITY OF CORRELATIONS IMPLIED IN FOREIGN-EXCHANGE OPTIONS

This paper evaluates the forecasting accuracy of correlations derived from implied volatilities in dollar-mark, dollar-yen, and mark-yen opt ions from January 1989 to May 1995. As a forecast of realized correlat ion between the dollar-mark and dollar-yen, implied correlation is com pared against three alternative forecasts based on time series data: h istorical correlation, RiskMetrics' exponentially-weighted moving aver age correlation, and correlation estimated using a bivariate GARCH(1,1 ) model. At the 1-month and 3-month forecast horizons, we find that im plied correlation outperforms, often significantly, these alternative forecasts. In combinations, implied correlation always incrementally i mproves the performance of other forecasts, but not the converse; in c ertain cases, historically-based forecasts contribute no incremental i nformation to implied forecasts. The superiority of the implied correl ation forecast holds even when forecast errors are weighted by realize d variances, reflecting correlation's contribution to the dollar varia nce of a multicurrency portfolio. (C) 1998 Elsevier Science Ltd. All r ights reserved.