The Interrelationship Between Implied and Realized Exchange Rate Volatility in India

This paper examines the relationship between the USD/INR implied volatility and future realized volatility by using non-overlapping monthly volatility data from April 2005 to March 2017. The empirical results suggest that the USD/INR implied volatility is biased, yet a better predictor of future realized volatility of the exchange rate than historical volatility and GARCH forecast. The out-of-sample forecast also shows that implied volatility outperforms both historical volatility and GARCH forecast in predicting future realized volatility. The implied volatility is found to be an efficient predictor vis-a-vis historical volatility as it subsumes all the information content of the historical volatility about future realized volatility. However, the GARCH forecast contains some incremental information about future realized volatility beyond the information contained in the implied volatility, though the predictive power of implied volatility remains higher than the GARCH forecast.