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Volatility Risk Premia and Exchange Rate Predictability

Lucio Sarno and Pasquale Della Corte
Authors registered in the RePEc Author Service: Tarun Ramadorai

No 9549, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: We investigate the predictive information content in foreign exchange volatility risk premia for exchange rate returns. The volatility risk premium is the difference between realized volatility and a model-free measure of expected volatility that is derived from currency options, and reflects the cost of insurance against volatility ?fluctuations in the underlying currency. We find that a portfolio that sells currencies with high insurance costs and buys currencies with low insurance costs generates sizeable out-of-sample returns and Sharpe ratios. These returns are almost entirely obtained via predictability of spot exchange rates rather than interest rate differentials, and these predictable spot returns are far stronger than those from carry trade and momentum strategies. Canonical risk factors cannot price the returns from this strategy, which can be understood, however, in terms of a simple mechanism with time-varying limits to arbitrage.

Keywords: exchange rate; Hedgers; Order flow; Predictability; Speculators; Volatility risk premium (search for similar items in EconPapers)
JEL-codes: F31 F37 G12 G13 (search for similar items in EconPapers)
Date: 2013-07
New Economics Papers: this item is included in nep-ifn and nep-mst
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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