Volatility Risk Premia and Exchange Rate Predictability

Della Corte, Pasquale, Ramadorai, Tarun and Sarno, Lucio (2013) Volatility Risk Premia and Exchange Rate Predictability. Centre for Economic Policy Research.

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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.

Item Type: Other Working Paper
Keywords: Exchange Rate, Hedgers, Order Flow, Predictability, Speculators, Volatility Risk Premium, finance
Subject(s): Finance
Date Deposited: 11 Mar 2014 17:26
Last Modified: 07 Dec 2018 14:00
URI: http://eureka.sbs.ox.ac.uk/id/eprint/5015

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