Implied Volatility Term Structure and Exchange Rate Predictability

Jose Ornelas and Roberto Mauad

No 492, Working Papers Series from Central Bank of Brazil, Research Department

Abstract: This paper provides empirical evidence of the predictive power of the currency implied volatility term structure (IVTS) on exchange rate behavior from both cross-section and time-series perspectives. Intriguingly, the direction of the prediction is not the same for developed and emerging markets. For developed markets, a high slope means low future returns, while for emerging markets this means high future returns. In order to analyze predictability from a cross-section perspective, we build portfolios based on the slope of the term structure, and thus present a new currency trading strategy. For developed (emerging) currencies, we buy (sell) the two currencies with the lowest slopes and sell (buy) those two with the highest slopes. The proposed strategy performs better than common currency strategies - carry trade, risk reversal and volatility risk premium - based on the Sharpe ratio, considering only currency returns, which supports the exchange rate predictability of the IVTS from a cross-section perspective.

Date: 2019-03
New Economics Papers: this item is included in nep-ifn and nep-rmg
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Citations: View citations in EconPapers (7)

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Journal Article: Implied volatility term structure and exchange rate predictability (2019)
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