Correlations implied by currency and cross-rate options

Correlations between exchange rate returns are a fundamental input in international portfolio selection problems. Heretofore, historical estimates of correlations have been used in studies of these problems. Recently, numerous cross-currency and cross-rate derivative products have been made available to investors. The valuation of these derivative products is affected by the expected correlation between exchange rate returns and hence offers an unique opportunity to imply an ex-ante estimate of correlation. The goal of this dissertation is to estimate and study the behavior of implied correlations between exchange rate changes using traded currency and cross-rate options. An extension of the Black-Scholes (1973) model is used to value the options. The data available allows for estimation of implied correlations between Dollar/Mark and Dollar/Pound rates of return and also between Dollar/Mark and Dollar/Yen rates of return. A second goal of this dissertation is to study the ability of these implied estimates to predict future correlations. For comparative purposes, historical estimates and time series models are also used. Empirical results from this study are mixed. For Dollar/Mark and Dollar/Pound rates of return, implied estimates outperform historical estimates. For Dollar/Mark and Dollar/Yen rates of return, implied estimates have significant predictive ability but are outperformed by historical estimates.