Volatility Risk Premia and Exchange Rate Predictability

We discover a new currency strategy with highly desirable return and diversification properties, which uses the predictive capability of currency volatility risk premia for currency returns. The volatility risk premium -- the difference between expected realized and model-free implied volatility -- reflects the costs of insuring against currency volatility fluctuations, and the strategy sells high-insurance-cost currencies and buys low-insurance-cost currencies. The returns to the strategy are mainly generated by movements in spot exchange rates rather than interest rate differentials, and the strategy carries a greater weight in the minimum-variance currency strategy portfolio than both carry and momentum. Canonical risk factors cannot price the returns from this strategy, which appear more consistent with time-varying limits to arbitrage.

This event is organised by the Econometric Institute.
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