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Volatility risk premia and exchange rate predictability

Pasquale Della Corte, Tarun Ramadorai and Lucio Sarno

Journal of Financial Economics, 2016, vol. 120, issue 1, 21-40

Abstract: We discover a new currency strategy with highly desirable return and diversification properties, which uses the predictive ability of currency volatility risk premia for currency returns. The volatility risk premium—the difference between expected realized volatility and model-free implied volatility—reflects the costs of insuring against currency volatility fluctuations. The strategy sells high insurance-cost currencies and buys low insurance-cost currencies. A distinctive feature of the strategy’s returns is that they are mainly generated by movements in spot exchange rates instead of interest rate differentials. We explore explanations for the profitability of the strategy, which cannot be understood using traditional risk factors.

Keywords: Exchange rates; Volatility risk premium; Predictability; Efficient currency portfolios (search for similar items in EconPapers)
JEL-codes: F31 F37 (search for similar items in EconPapers)
Date: 2016
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Citations: View citations in EconPapers (80)

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Working Paper: Volatility Risk Premia and Exchange Rate Predictability (2013) Downloads
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jfinec:v:120:y:2016:i:1:p:21-40

DOI: 10.1016/j.jfineco.2016.02.015

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