Abstract

In this chapter, we examine the use of nonparametric Neural Network Regression (NNR) and Recurrent Neural Network (RNN) regression models for forecasting and trading currency volatility, with an application to the GBP/USD and USD/JPY exchange rates. Both the results of the NNR and RNN models are benchmarked against the simpler GARCH alternative and implied volatility. Two simple model combinations are also analysed.

The intuitively appealing idea of developing a nonlinear nonparametric approach to forecast FX volatility, identify mispriced options and subsequently develop a trading strategy based upon this process is implemented for the first time on a comprehensive basis. Using daily data from December 1993 through April 1999, we develop alternative FX volatility forecasting models. These models are then tested out-of-sample over the period April 1999-May 2000, not only in terms of forecasting accuracy, but also in terms of trading efficiency. In order to do so, we apply a realistic volatility trading strategy using FX option straddles once mispriced options have been identified.

Allowing for transaction costs, most trading strategies retained produce positive returns. RNN models appear as the best single modelling approach yet, somewhat surprisingly, a model combination which has the best overall performance in terms of forecasting accuracy fails to improve the RNN-based volatility trading results.

Another conclusion from our results is that, for the period and currencies considered, the currency option market was inefficient and/or the pricing formulae applied by market participants were inadequate.

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