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 options from January 1989 to May 1995. As a forecast of realized correlation between the dollar-mark and dollar-yen, implied correlation is compared against three alternative forecasts based on time series data: historical correlation, RiskMetrics' exponentially-weighted moving average correlation, and correlation estimated using a bivariate GARCH(1,1) model. At the 1-month and 3-month forecast horizons, we find that implied correlation outperforms, often significantly, these alternative forecasts. In combinations, implied correlation always incrementally improves the performance of other forecasts, but not the converse; in certain cases, historically-based forecasts contribute no incremental information to implied forecasts. The superiority of the implied correlation forecast holds even when forecast errors are weighted by realized variances, reflecting correlation's contribution to the dollar variance of a multicurrency portfolio. (C) 1998 Elsevier Science Ltd. All rights reserved.