The Application of Error Correction Model in Forecasting Market Volatility on Emerging Currency Options Markets

The paper presents examples of application of error correction models (ECM) in forecasting daily changes of market volatility recorded on currency options markets in Poland, Hungary and South Africa. The models are based on the observed correlation between daily changes of spot rates and daily changes of volatility levels quoted by interbank brokers.In order to define both short term and long term influence of spot rate on market volatility, ECM models were calibrated. Models show that change of market volatility can be described as function of daily change of spot rate and relationship between spot level and volatility level. Research shows negative correlation between market volatility and a strength of the local currency. The relationship seems to be asymmetric, with much stronger reaction after local currency weakening