International Review of Financial Analysis

14 (2005) 165 – 176

Paramater estimation bias and volatility scaling

in Black–Scholes option prices
Jonathan A. Batten a,1, Craig A. Ellis b,*
a
College of Business Administration, Seoul National University, 151-742 San 56-1, Sillim-Dong,
Kwanaku-Ku, Seoul, South Korea
b
School of Economics and Finance, University of Western Sydney, Locked Bag 1797, Penrith South DC,
NSW 1797, Australia

Abstract

When asset returns conform to a Gaussian distribution, the moments of the distribution over long
return intervals may be estimated by scaling the moments of shorter return intervals. While it is well
known that asset returns are not normally distributed, a key empirical question concerns the effect
that scaling the volatility of dependent processes will have on the pricing of related financial assets.
This study investigates the return properties of the most important currencies traded in spot markets
against the U.S. dollar: the Japanese yen, the British pound, and the Swiss franc during the period
November 1983 to April 2004. The novelty of this paper is that the volatility properties of the series
are tested utilising statistical procedures developed from fractal geometry, with the economic impact
determined within an option-pricing framework.
D 2004 Elsevier Inc. All rights reserved.

JEL classification: C49; F31; G15

Keywords: Scaling volatility; Long-term dependence; Foreign exchange

1. Introduction

Linear rescaling is the term used to describe the process by which the moments of a
distribution, when measured over a short time interval (e.g., daily), can be scaled to
replicate the equivalent moments for a long time interval (e.g., annual). When properly

* Corresponding author. Tel.: +61-2-4620-3250; fax: +61-2-4626-6683.

E-mail addresses: jabatten@snu.ac.kr (J.A. Batten), c.ellis@uws.edu.au (C.A. Ellis).
1
Fax: +82-2-882-0547.

1057-5219/$ - see front matter D 2004 Elsevier Inc. All rights reserved.
doi:10.1016/j.irfa.2004.06.008
166 J.A. Batten, C.A. Ellis / International Review of Financial Analysis 14 (2005) 165–176

rescaled, the original series and the scaled series are statistically indistinguishable and the
moments of the distribution, therefore, are identical.
While nonnormality of returns is a feature of many financial time series (Fama, 1965;
Pagan, 1996), many market valuation models require an annualised risk coefficient. Despite
the widespread practice of linearly rescaling risk by the square root of time (MT), Diebold,
Hickman, Inoue, and Schuermann (1988) argue strongly against this on the basis that the
procedure overestimates long horizon risk. An example of a common application of scaling
in financial time series involves the annualising of risk in the Black – Scholes Option Pricing
Model. Using a set of testable empirical conditions developed by Batten and Ellis (2001),
this paper examines the theoretical economic implications of incorrectly scaling risk for a
series of in-the-money, at-the-money, and out-of-the-money European call and put foreign
currency options written on the GBP/USD, JPY/USD, and SWF/USD. The economic
question addressed by this paper is whether dependence and nonnormality have a significant
price impact. Employing a simple Black –Scholes model for pricing currency options, we
find that the incorrect scaling of risk leads to incorrect pricing decisions with the resulting
price impact being that call and put option values tend to be underpriced.

2. Scaling the volatility of financial asset returns

Empirical research in foreign currency markets has revealed extensive evidence of

nonnormality in the distributions of daily and weekly returns for spot and forward
currencies (Kearns & Pagan, 1997; Tucker & Pond, 1988). Nonlinear dependence,
consistent with long memory, has also been identified in many currency series (Byers &
Peel, 2001; Cheung, 1993; Muller et al., 1990; Peters, 1994). Statistical dependence has
particular implications for modelling the behaviour of financial market asset prices.
When asset returns are not IID, incorrectly annualising risk by the square root of time
(MT) will either overestimate or underestimate the true level of risk associated with an
investment.
The focus of this paper is the economic impact of incorrectly scaling volatility on
Black – Scholes foreign currency options. To determine the likely impact of linear
rescaling, tests are first conducted to measure the value of the scale exponent for the
three currency pairs under observation. The economic impact is then measured by
calculating Black –Scholes option premiums using both implied annual volatility and
observed annual volatility. The first test conducted in this study is for the relation
described by the power law function

y~xH ð1Þ

Derived from the premise that amplitude and time do not vary independently, but
instead are dependent, Eq. (1) provides that the y-axis measure is proportional to time (x)
raised to a scale exponent, H. Using OLS regression techniques, the scale exponent will be
estimated as the coefficient c1 in the regression

logðrk Þ ¼ c0 þ c1 logðkÞ ð2Þ

 J.A. Batten, C.A. Ellis / International Review of Financial Analysis 14 (2005) 165–176 167

where k is the length of the return interval and rk is the standard deviation of k interval
returns; k = 1, 2, . . ., 252 days. This technique is similar to the one employed by Muller et
al. (1990) for intraday foreign exchange rates. Continuously compounded returns for the
three spot currency pairs are calculated as Xk = ln( Pt /Pt  k) for each of the nominated
values of k. The volatility of returns is estimated by the second moment of the distribution
of each returns series. Under the null hypothesis that each currency series conforms to an
independent Gaussian distribution, the expected value of the scale exponent is H = 0.5.
Tests for the level of dependence in returns are then conducted using the classical
rescaled adjusted range statistic (R*/r)n. Proposed by Hurst (1951), the classical rescaled
adjusted range is calculated as
" #
Xk X k
ðR*=rÞn ¼ ð1=rn Þ Max ðXj  X̄n Þ  Min ðXj  X̄n Þ ð3Þ
1V kV n 1V kV n
j¼1 j¼1

where X̄n is the sample mean (1/n)RjXj and rn is the sample standard deviation
" #0:5
Xn
2
rn ¼ 1=n ðXj  X̄n Þ ð4Þ
j¼1

For a given series of length N, empirical estimates of the classical rescaled adjusted
range are derived by firstly dividing the series length into d times subseries n of length
n V N. Estimating Eqs. (3) and (4) over each of d subseries, the scale exponent can then be
estimated by an OLS regression of the form
logðR*=rÞn ¼ a þ blogðnÞ þ e ð5Þ
where the estimated b coefficient is the value of the scale exponent (H). For time series
exhibiting positive long-term dependence, the observed value of the exponent will be
H >0.5. Time series containing negative dependence are alternatively characterised by
exponent values H < 0.5. Being nonparametric in nature, the advantage of the classical
rescaled adjusted range is that the test can be conducted independently of the underlying
series distribution.2

3. Pricing foreign currency options

To examine the economic impact of linear rescaling on Black – Scholes foreign

currency option prices, the return properties of three currencies traded in spot markets
against the U.S. dollar: the British pound (GBP/USD), the Japanese yen (JPY/USD), and
the Swiss franc (SWF/USD), from 1 November 1983 to 30 April 2004, are first
investigated. The BIS (2002) triennial survey of foreign exchange market activity
estimates that these currency pairs accounted for 42% of total daily turnover in the spot

2
Traditionally used as a test for long-term dependence in time-series data, the classical rescaled adjusted
range is also preferred for the fact that the output is directly translatable to the scale exponent. Other similar tests
for dependence (e.g., Lo, 1991) cannot be easily translated and have not been considered for this reason.
168 J.A. Batten, C.A. Ellis / International Review of Financial Analysis 14 (2005) 165–176

Table 1
Descriptive statistics of the spot foreign currency interday returns
Currency, N = 5169 GBP/USD JPY/USD SWF/USD
Mean  3.40e-05  1.40e-04  9.60e-05
Standard deviation 6.29e-03 6.85e-03 7.40e-03
Skewness  1.08e-03  5.30e-01  1.92e-01
Excess kurtosis 3.830 4.561 2.094
Sum of ln returns  0.178  0.743  0.497
Autocorrelation at Lag 1 0.064 0.037 0.018
t Statistic 4.61 2.67 1.72
LBQ 21.24 7.13 2.86
P value .000 .008 .190
Anderson – Darling 36.564 43.491 16.730
P value .000 .000 .000
Ryan – Joiner 0.981 0.975 0.991
P value < .01 < .01 < .01

foreign exchange markets in 2001 [JPY/USD (23%), GBP/USD (13%), and SWF/USD
(6%)].3 Trading also occurs on a 24-h basis, with almost instantaneous transmission of
news items to market participants. Consequently, these markets are as close to the efficient
market ideal as is currently possible. Overall, although the three series provide evidence of
nonnormality in the form of leptokurtic returns with a slight positive autocorrelation
structure, results provided in Table 1 provide no compelling evidence that the appropriate
scale exponent should be other than H = 0.5. Tests for the mean stationarity of returns
confirms that all the returns series are unit-root stationary. The results implies that linearly
rescaling short return horizon standard deviations should produce correct estimates of the
annual standard deviation (risk) for each currency.
The scaling properties of daily spot foreign currency returns are then studied using two
tests. The first is an investigation of the existence of a power law for the standard deviation
of returns over different return intervals. The second is a measure of the level of
dependence in each returns series. Regression scale exponents for each currency pair
are presented in Table 2. Calculated using Eq. (2), the regression scale exponent c1 is the
rate of change in observed k interval standard deviations for the intervals k = 1 to 252.
Values in Table 2 confirm that the standard deviations of all currency pairs, except the
GBP/USD, scale at greater than the square root of time. However, all the values are
substantially lower than shown by Muller et al. (1990) for absolute changes in intraday
currency prices, and Peters (1994) for daily spot currency returns. One implication of this
result is that short interval risk is a poor predictor of risk over long time intervals. Option
prices based on implied annual standard deviations are therefore expected to be lower than
those derived from the observed annual standard deviations.
The second test conducted is the classical rescaled adjusted range as given in Eqs. (3)
and (4). Estimated values for the classical rescaled adjusted range for each series and their
respective bootstrap means and standard deviations are provided in Table 3.

3
Accounting for 38% of foreign exchange activity in 2001, the Euro was only introduced on 1 January 1999.
 J.A. Batten, C.A. Ellis / International Review of Financial Analysis 14 (2005) 165–176 169

Table 2
Regression scale exponents for k interval standard deviations, k = 1 to 252
GBP/USD JPY/USD SWF/USD
Regression scale exponent, c1 0.505 0.549 0.528
Standard error (0.002) (0.001) (0.001)
The table presents the tests of the regression scale exponent, c1, for the regression log(rk) = c0 + c1log(k). Standard
deviations are measured for returns at intervals of k = 1 to 252 days. Under the null hypothesis, H0, the value of
the regression scale exponent should be c1 = 0.5. Correlation between the dependent variables rk prevents testing
the statistical significance of the c1 estimates using usual (parametric) means. The economic significance of the
results in the table is presented using a variation of the Black – Scholes Option Pricing Model for currency
options.

Under the null of no long-term dependence, values for the classical rescaled adjusted
range are expected to be within 1.96 standard deviations of their expected value at the 0.05
level of significance, and within 1.645 standard deviations of their expected value at the
0.10 level. Compared to their mean value, the null is accepted for all currency pairs at the
0.05 level and only rejected for the JPY/USD at the 0.10 level. This result does not,
however, provide sufficient evidence that the series are random. In combination with
results provided in Table 2, results attributable to the classical rescaled adjusted range do
provide evidence of at least positive short-term dependence in each currency series.
Using a variation of the Black – Scholes Option Pricing Model for foreign currency
options, implied annual standard deviations for intervals of n = 1, 5, and 22 lags are
used to price in-the-money, at-the-money, and out-of-the-money call and put options for
each of the three currency pairs. Implied annual standard deviations are estimated using
Eq. (6).

½r2 ðPt  Ptk Þ0:5 ¼ ðk=nÞ0:5 ½r2 ðPt  Ptn Þ0:5 ð6Þ

where l z n z 1, l z k z n, and Pt are Pt  k are the natural logarithms of daily prices.

In the calculation of the Black– Scholes model, spot exchange rates for each currency
are their actual value as of 30 April 2004; in-the-money and out-of-the-money exchange
rates are initially set at F 20.0% of the spot exchange rate. Six-month Euro rates for the

Table 3
Rescaled range statistics for spot foreign currency interday returns
GBP/USD JPY/USD SWF/USD
(R/r)n 0.5150 0.6006 0.5726
E(R/r)n
Mean 0.5275 0.5242 0.5236
Standard deviation 0.0409 0.0417 0.0428
The table presents tests for dependence in spot foreign currency interday returns [ln( Pt /Pt  1)], as calculated using
the classical rescaled adjusted range statistic, (R/r)n. The expected rescaled range E(R/r)n for each currency pair is
calculated using a bootstrap method where interday returns for each currency are scrambled 1000 times. (R/r)n
values for each iteration are calculated and their mean and standard deviation used to estimate upper and lower
confidence intervals. The null hypothesis of no dependence is accepted at the 0.05 level if observed values of (R/r)n
in the table are within F 1.96 standard deviations of their respective mean values.
170 J.A. Batten, C.A. Ellis / International Review of Financial Analysis 14 (2005) 165–176

four currencies as of 30 April 2004 are used to proxy domestic and foreign risk-free
interest rates, and the time to maturity is 0.5 years (180 days based on a 360-day year).
Prices in the table are expressed as 100 times the Black –Scholes price. From Hypothesis 1
of Batten and Ellis (2001), under the assumption that each of the three currency pairs are
indeed Gaussian, option values derived from the rescaled standard deviations should not
be different from those using the observed annual standard deviations.
Hypothesis 1. The estimated risk of an asset (rq*) over a long time interval (k) is a linear
function of the observed risk over a shorter time interval (n) scaled at the square root of
time

H0 : rq* ¼ ð k=n Þ 0:5 r ð Pt  Ptn Þ

Ha : rq* p ð k=n Þ 0:5 r ð Pt  Ptn Þ

Except for options written on the GBP/USD, option values derived from rescaled
standard deviations consistently underestimated their values based on the observed annual
standard deviations.4 Values for out-of-the-money call contracts are underestimated by a
maximum of 79.1% (JPY/USD n = 1) to a minimum of 27.4% (GBP/USD n = 1). For out-
of-the-money puts, it is a maximum of 78.5% (JPY/USD n = 1). At-the-money call
contract values are underestimated by a maximum of 23.0% (JPY/USD n = 1) and a
minimum of 4.0% (GBP/USD n = 1). Equivalent put option values are undervalued by a
maximum of 12.9% (JPY/USD n = 1) and a minimum of 2.3% (GBP/USD n = 1). Finally,
prices for in-the-money calls and puts derived from the rescaled standard deviations are
undervalued by less than 0.5%. The result for in-the-money options is consistent with the
option value being determined mostly by its intrinsic value rather than the level of
volatility, with the reverse being the case for out-of-the money options. The results are also
consistent with lower (higher) option Vegas for in-the-money (out-of-the-money) posi-
tions. As shown in Table 5, the degree of underpricing for all currency pairs is also shown
to be highly statistically significant when using a one-tailed t test for mean absolute
percentage differences between currency option prices using implied versus observed
annual volatilities, confirming that scaling risk by MT underestimates the value of the
option.

4. Sensitivity to other factors

Dependence in the conditional variance of the distributions of the currency returns, or

predictable returns may provide alternate hypotheses over dependence in the mean, in
explaining rejection of the Gaussian null. Lo and Wang (1995) define predictable returns
as where asset prices conform to a trending Ornstein – Uhlenbeck (O –U) process.5 A key

4
GBP/USD call and put prices for values of n = 5 and n = 21 exhibited small percentage overpricing.
5
Log prices according to a trending O – U process are the sum of a zero-mean stationary autoregressive
Gaussian process and a deterministic linear trend.
 J.A. Batten, C.A. Ellis / International Review of Financial Analysis 14 (2005) 165–176 171

characteristic of O – U processes is that their first-order autocorrelations are always less

than or equal to zero. Using Monte Carlo simulation techniques, Lo and Wang show that
standard Black – Scholes option prices will be too low relative to those implied by the O –
U-modified Black –Scholes model when returns are predictable, with the precise effect on
price being dependent on the underlying option Vega. However, given that the three
currency pairs tested all exhibit positive (as opposed to negative) first-order autocorrela-
tion, and that all the calculated option Vegas are less than 1%, the potential price impact of
predictable returns is negligible.
Time series with conditionally heteroskedastic variances will not scale according to the
linear rule when the series increments are measured over short time intervals, yet will
revert to the linear rule as the returns interval lengthens. Test results for conditional
heteroskedasticity in the four currency series show significant evidence of at least ARCH
type disturbances in short interval returns, yet decreasing levels of significance at longer
return intervals. The results are consistent with the aforementioned tendency of simple
models of conditional heteroskedasticity to revert to Gaussian models over longer return
intervals.6
Developing a GARCH option-pricing model, Duan (1995) shows that the Black –
Scholes model will generally underprice both in-the-money and out-of-the-money
options. On the basis of the Monte Carlo simulations performed by Duan, the levels
of underpricing of out-of-the-money call options by the Black – Scholes model observed
in this study would imply an initial conditional volatility approximately 340 –380%
above the stationary level for the currency returns series. Empirical test results of the
level of conditional volatility in the currency returns series easily fail to support the
proposition.
The sensitivity of these findings to changes in the underlying spot foreign exchange rate
may also be tested. By way of example, using SWF/USD call options, Fig. 1 shows the
relationship between percentage mispricing and the moneyness of the option for different
values of the interval length n, given a constant time to maturity, which, in this example, is
180 days. As per Table 5, percentage mispricing is the percent pricing error calculated as
the implied option value (using implied annual volatility) less the option value (using the
observed annual volatility) expressed as a percentage of the option value. Ceteris paribus,
mispricing is a positive function of the difference between the implied and observed
annual volatility as indicated by the option Vega. Moneyness measures the degree to which
the option is in-the-money or out-of-the-money. Positive moneyness values indicate that
the option is in-the-money, while negative values indicate an out-of-the-money option. An
option that is at-the-money has zero moneyness. Moneyness in Fig. 1 is measured over a
range of spot exchange rates F 40% above and below the option exercise. The interval
length n corresponds to the shorter time interval in Eq. (6).
In combination with the results already presented in Tables 4 and 5, Fig. 1 provides
evidence consistent with dollar Vegas being highest for at-the-money options, while
percentage changes in price are highest for deep out-of-the-money options, and zero for

6
Test results using the Lagrange Multiplier Test and asymptotic t test for autocorrelation in large samples are
available from the authors by request.
172 J.A. Batten, C.A. Ellis / International Review of Financial Analysis 14 (2005) 165–176

Fig. 1. Sensitivity of foreign currency option values to moneyness and interval length. The figure shows the
percentage of mispricing for a SWF/USD call option with 180 days to maturity. Mispricing measures the percent
pricing error calculated as the implied option value using linear rescaling, less the option value using the observed
annual standard deviation, expressed as a percentage of the option value. A level of mispricing of  1.0 indicates
that the option is undervalued by 100%. Moneyness is a measure of the percentage difference in the option
exercise and spot foreign exchange rate. Positive moneyness values indicate that the option is in-the-money, while
negative values indicate an out-of-the-money option. At option which is at-the-money has zero moneyness. The
interval length n corresponds to the shorter time interval in Eq. (1). The figure shows that out-of-the-money
options have the highest percent change in price, per unit change of volatility (as implied from the interval length,
n). Mispricing decreases with increasing interval lengths n, as the implied annual volatility converges to the
observed annual volatility. The relationship described in the figure is constant for both call and put options, and is
greatest for JPY/USD foreign currency options and lowest for GBP/USD foreign currency options.

deep in-the-money options. The change in Vega with respect to changes in the
underlying asset value is referred to as the option Vanna. Volga, or Vomma, alternatively
measures the change in an option Vega with respect to changes in volatility. One
implication of results depicted in Fig. 1 is that the parameter estimation bias due to linear
rescaling of short horizon volatilities is higher for option Vannas (as indicated along the x
axis), than for option Volgas (as indicated along the z axis). These findings are consistent
for both call and put options. As implied by the values for the regression scale exponents
in Table 2, the percentage mispricing is highest for the JPY/USD and lowest for the
GBP/USD.
Sensitivity analysis is also conducted with respect to changes in the time to maturity of
the option and interval length used to calculate implied annual volatility. Using at-the-
money JPY/USD call and put options, by way of example, Fig. 2 demonstrates the
relationship between percentage mispricing and time to maturity.
Given a constant option Vega (as indicated by movement along the x axis), Fig. 2A
demonstrates a positive relationship between percentage mispricing and time to maturity
for at-the-money call options. For put options, however, the relationship is shown to be
 J.A. Batten, C.A. Ellis / International Review of Financial Analysis 14 (2005) 165–176 173

Table 4
Foreign currency option values calculated using implied annual standard deviations
Currency Exchange rate Option exercise 1a 5b 22c 252d
(A) In-the-money
Call
GBP/USD 1.7697 1.4158 32.3446 32.3477 32.3507 32.3468
JPY/USD 9.1609 7.3287 162.5033 162.5365 162.5989 162.8605
SWF/USD 0.7586 0.6069 14.0429 14.0436 14.0469 14.0679
Put
GBP/USD 1.7697 2.1236 37.9717 37.9771 37.9821 37.9754
JPY/USD 9.1609 10.9930 201.6170 201.6544 201.7251 202.0251
SWF/USD 0.7586 0.9103 16.1264 16.1277 16.1334 16.1685

(B) At-the-money
Call
GBP/USD 1.7697 1.7697 3.6285 3.8387 3.9890 3.7806
JPY/USD 9.1609 9.1609 19.3207 20.2157 21.5368 25.0804
SWF/USD 0.7586 0.7586 2.0161 2.0337 2.1048 2.4114
Put
GBP/USD 1.7697 1.7697 6.4398 6.6500 6.8003 6.5919
JPY/USD 9.1609 9.1609 38.8727 39.7677 41.0887 44.6324
SWF/USD 0.7586 0.7586 3.0523 3.0700 3.1411 3.4477

(C) Out-of-the-money
Call
GBP/USD 1.7697 2.1236 0.0098 0.0152 0.0202 0.0135
JPY/USD 9.1609 10.9930 0.1076 0.1450 0.2157 0.5156
SWF/USD 0.7586 0.9103 0.0222 0.0235 0.0292 0.0643
Put
GBP/USD 1.7697 1.4158 0.0053 0.0084 0.0114 0.0075
JPY/USD 9.1609 7.3287 0.0978 0.1310 0.1934 0.4550
SWF/USD 0.7586 0.6069 0.0113 0.0120 0.0153 0.0362
The economic significance of incorrect volatility scaling is demonstrated in this table using a variation of the
Black – Scholes Option Pricing Model for foreign currency options. Here, annualised standard deviation estimates
for intervals of n = 1, 5, and 22 and observed standard deviation for 252 lags are used to price in-the-money, at-
the-money, and out-of-the-money call and put options for each of the three currency pairs. Spot exchange rates for
each currency are their actual value as of 30 April 2004. In-the-money and out-of-the-money exchange rates are
set at F 20.0% of the spot exchange rate. Six-month Euro rates for the four currencies as of 30 April 2004 are
used to proxy domestic and foreign risk-free interest rates. The time to maturity is 0.5 years (180 days based on a
360-day year). Prices are expressed as 100 times. The table provides four sets of call and put option prices: (a)
option value using an implied annual standard deviation from the standard deviation of daily returns; (b) option
value using an implied annual standard deviation from the standard deviation of weekly returns; (c) option value
using an implied annual standard deviation from the standard deviation of monthly returns; (d) option value using
observed standard deviation of annual returns.

negative in Fig. 2B. Starting from the position that option values increase with increasing
time to maturity, Fig. 2A shows that call option values calculated using implied annual
volatility increase at a slower rate than when value is calculated using observed annual
volatility. The divergence in option values as time to maturity increases therefore results in
higher percentage mispricing. By contrast, put option values calculated using implied
annual volatility increase at a faster rate than those using observed annual volatility. The
174 J.A. Batten, C.A. Ellis / International Review of Financial Analysis 14 (2005) 165–176

Table 5
Mean absolute percent forecast error for currency option prices using implied annual standard deviations
n=1 n=5 n = 22
(A) In-the-money
Call
Mean absolute percent forecast error (Standard error) 0.1345 (0.001) 0.1247 (0.001) 0.1073 (0.001)
t Statistic 2.068* 2.033* 2.252*
Put
Mean percent forecast error (Standard error) 0.1574 (0.001) 0.1468 (0.001) 0.1277 (0.001)
t Statistic 2.079* 1.985* 2.180*

(B) At-the-money
Call
Mean percent forecast error (Standard error) 14.4615 (0.056) 12.199 (0.054) 10.785 (0.027)
t Statistic 2.604* 2.243* 4.041**
Put
Mean percent forecast error (Standard error) 8.893 (0.033) 7.579 (0.034) 6.664 (0.018)
t Statistic 2.680* 2.263* 3.758**

(C) Out-of-the-money
Call
Mean percent forecast error (Standard error) 57.3238 (0.155) 49.1930 (0.186) 53.9258 (0.027)
t Statistic 3.704** 2.641* 20.321**
Put
Mean percent forecast error (Standard error) 58.772 (0.152) 50.398 (0.187) 56.168 (0.015)
t Statistic 3.877** 2.699* 36.747**
The table presents the mean absolute percent forecast error (MAPE), the standard error of the mean, and its
statistical significance. Panel (A) shows results for the implied in-the-money call and put values given in Table 4.
Panels (B) and (C) show results for implied at-the-money and out-of-the-money, respectively. The percent
forecast error is calculated as the implied option value using linear rescaling, less the option value using the
observed annual standard deviation, expressed as a percentage of the option value. The MAPE is the mean
absolute error for the three currencies. Under the null hypothesis, the expected value of the MAPE is zero. The t
statistic shows the statistical significance of the MAPE and is measured using the one-tailed t test for the
difference between two mean values. The 0.10 and 0.05 critical values for the t statistic are 2.35 and 3.18,
respectively. Values of the t statistic in the table in excess of the critical values indicate that the MAPE is
significantly different from zero.
* Significant at the 0.10 level.
** Significant at the 0.05 level.

resulting price convergence, therefore, yields lower percent mispricing as time to maturity
increases.
The nonlinear change in percentage mispricing for call and put options given
increasing time to maturity is consistent with the nonlinear relationship between Theta
and time to maturity. That mispricing in call (put) option values increases (decreases) with
increasing time to maturity, is consistent evidence that the change in Theta with respect to
time is smaller for call options than for puts. Consistent with the fact that implied annual
volatilities converge to observed annual volatilities as the interval length (n) increases, the
percentage mispricing for call and put options in Fig. 2 decreases for higher values of n.
One implication of results depicted in Fig. 2 is that the parameter estimation bias due to
linear rescaling of short horizon volatilities is greatest for at-the-money call options with a
 J.A. Batten, C.A. Ellis / International Review of Financial Analysis 14 (2005) 165–176 175

Fig. 2. Sensitivity of foreign currency option values to time to maturity and interval length. The figure shows the
percentage of mispricing for an at-the-money JPY/USD call option and an equivalent at-the-money put option.
The figure shows that the percentage of mispricing is positively related to the time to maturity for call options, and
negatively related to the time to maturity for put options. As above, the percentage mispricing decreases with
increasing interval lengths n, as the implied annual volatility converges to the observed annual volatility.
Mispricing is again greatest for JPY/USD foreign currency options and lowest for GBP/USD foreign currency
options.
176 J.A. Batten, C.A. Ellis / International Review of Financial Analysis 14 (2005) 165–176

high time value. Consistent with previous results, this bias is lowest for GBP/USD call
and put options.

5. Summary and conclusions

This paper examines long-term returns for three major spot foreign currencies against
the U.S. dollar. Using a simple Black – Scholes foreign currency option-pricing model,
linearly rescaled volatility estimates were shown to misprice option values by as much as
23.0% for at-the-money contracts. Furthermore, these results were shown to be highly
sensitive to changes in the moneyness of the option and, to a lesser extent, time to
maturity. These results are important because they demonstrate that small deviations from
statistical independence in asset returns can result in significant economic benefits or costs.
Conditional heteroscedasticity and predictable returns have both been discounted as
possible alternative explanations for this result. The results highlight the need for investors
to consider the underlying distribution and independence of returns when using short
horizon returns to estimate long horizon risk.

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