Understanding Exchange Rate Dynamics: What Does the Term Structure of FX Options Tell Us

This paper proposes using foreign exchange (FX) options with dierent strike prices and maturities (\the term structure of volatility smiles") to capture both FX expectations and risks. Using daily options data for six major currency pairs, we show that the cross section and term structure of options-implied standard deviation, skewness and kurtosis consistently explain not only the conditional mean but also the entire conditional distribution of subsequent currency excess returns for horizons ranging from one week to twelve months. This robust empirical pattern is consistent with a representative expected utility maximizing investor who, in addition to caring about the mean and variance, also cares about the skewness and kurtosis of the return distribution. We also nd that exchange rate movements, which are notoriously dicult to model empirically (\the exchange rate disconnect puzzle"), are in fact well-explained by the term structures of forward premia and options-implied higher moments. Our results suggest that the perennial problems faced by the empirical exchange rate literature are most likely due to overly restrictive assumptions inherent in prevailing testing methods, which fail to properly account for the forward-looking property of exchange rates and potential skewness or excess kurtosis in the conditional distribution of FX movements.