Variance Risk Premiums and the Forward Premium Puzzle
67 Pages Posted: 22 Aug 2012 Last revised: 22 Jun 2016
Date Written: June 17, 2016
We provide new empirical evidence that world currency and U.S. stock variance risk premiums have nonredundant and significant predictive power for the appreciation rates of twenty-two currencies with respect to the U.S. dollar, especially at the four-month and one-month horizons, respectively. The heterogeneous exposures of currencies to the currency variance risk premium are systematically rising along the line of inflation risk. We rationalize these findings in a consumption-based asset pricing model, with local consumption uncertainty and global inflation uncertainty characterized, respectively, by the stock and currency variance risk premiums.
Keywords: Currency return predictability, currency and stock variance risk premiums, forward premium puzzle, local consumption uncertainty, global inflation uncertainty.
JEL Classification: G12, G15, F31
Suggested Citation: Suggested Citation