Forecasting and Trading Currency Volatility: An Application of Recurrent Neural Regression and Model Combination

In this paper, we examine the use of GARCH models, Neural Network Regression (NNR), Recurrent Neural Network (RNN) regression and model combinations for forecasting and trading currency volatility, with an application to the GBP/USD and USD/JPY exchange rates. Both the results of the NNR/RNN models and the model combination results are benchmarked against the simpler GARCH alternative. The idea of developing a nonlinear nonparametric approach to forecast FX volatility, identify mispriced options and subsequently develop a trading strategy based upon this process is intuitively appealing. Using daily data from December 1993 through April 1999, we develop alternative FX volatility forecasting models. These models are then tested out-of-sample over the period April 1999-May 2000, not only in terms of forecasting accuracy, but also in terms of trading efficiency: In order to do so, we apply a realistic volatility trading strategy using FX option straddles once mispriced options have been identified. Allowing for transaction costs, most trading strategies retained produce positive returns. RNN models appear as the best single modelling approach yet, somewhat surprisingly, model combination which has the best overall performance in terms of forecasting accuracy, fails to improve the RNN-based volatility trading results. Another conclusion from our results is that, for the period and currencies considered, the currency option market was inefficient and/or the pricing formulae applied by market participants were inadequate. * Christian Dunis is Girobank Professor of Banking and Finance at Liverpool Business School and Director of CIBEF (E-mail: [email protected]). The opinions expressed herein are not those of Girobank. ** Xuehuan Huang is an Associate Researcher with CIBEF. *** CIBEF – Centre for International Banking, Economics and Finance, JMU, John Foster Building, 98 Mount Pleasant, Liverpool L3 5UZ. We are grateful to Professor Ken Holden and Professor John Thompson of Liverpool Business School for helpful comments on an earlier version of this paper.