Large Moves in the Foreign Exchange Market

Centre for Endowment Asset Management (CEAM)
Centre for Endowment Asset Management (CEAM)

Overview

Foreign exchange markets are often described as efficient and unpredictable, especially when it comes to very large daily moves in exchange rates. These “threesigma” events – where a currency moves several times more than its usual daily volatility – are typically treated as sudden shocks that nobody could have seen coming. This research challenges that view. 

Writing notes after while analysing financial data.

Authors

Alex Kostakis

Professor of Finance at the University of Liverpool Management School

Brandon McBride

PhD Candidate in the Finance at Cambridge Judge Business School, University of Cambridge

Lucio Sarno

Cambridge Judge Business School, University of Cambridge

Junxuan Wang

Assistant Professor in the Thrust of Financial Technology, HKUST (Guangzhou)

About the research

This research asks whether some of these large currency moves are, in fact, anticipated by markets in real time, and if so, how we can detect that anticipation. The focus is on the information contained in FX option prices, which reflect what market participants expect about future volatility. 

A key idea is to look at the term structure of implied volatility: the difference between short term and longer term option implied volatilities. When short term implied volatility rises above longer term implied volatility, the curve becomes “inverted”. The project shows that such inversions are strong signals that markets expect a big move in the exchange rate soon, although not necessarily whether it will be up or down. 

Findings

Using a large dataset from CME of options and spot FX for 6 major currency pairs (such as EUR/USD, GBP/USD and JPY/USD) from 2006–2024, the research finds: 

  • Large FX moves are rare but account for a disproportionate amount of overall risk. 
  • Before these large moves, currencies tend to drift gradually and option markets display clear warning signs, especially an inverted volatility term structure. 
  • These signals are statistically robust across currencies and remain powerful even after controlling for other risk measures and market stress indicators. 

The project also shows that simple trading strategies that buy options (strangles) only when the term structure is strongly inverted can earn attractive riskadjusted returns, even after realistic trading costs. 

This project illustrates how theory, data and market microstructure combine to shed light on “tail events” in FX, and how quantitative tools can be used both for understanding risk and designing practical trading or hedging strategies. 

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