Capturing all the information in foreign currency option prices: solving for one versus two implied variables
The information content of option prices has traditionally been expressed in an implied volatility parameter which is characterized as capturing the markets expectations about future volatility of the underlying asset. Researchers normally solve for an implied volatility alone. A more recent trend has been to solve for both an implied interest rate and standard deviation simultaneously. This study compares the proficiency of these two techniques in capturing the information in the market prices of foreign currency options. The results show that solving for two implied variables consistently yields less information than solving for an implied volatility alone. This raises the implication that by trying to reduce one source of bias by solving for two variables simultaneously, researchers may be introducing a more serious source of error resulting in a dilution of the available information.