Global Variance Risk Premium and Forex Return Predictability

Abstract

I use forward-looking information available in stock market volatility indices to predict forex returns. In particular, I find that equity variance risk premiums (VRPs) — the difference between the risk-neutral and statistical expectations of market return variation — predict forex returns at a one-month horizon, both in-sample and out-of-sample. Moreover, compared to the major currency carry predictors, global VRP has more predictive power for currency carry trade returns, bilateral forex returns, and excess equity return differentials. To formalize the link between equity VRPs and forex returns, I provide a long-run risk model with stochastic volatility and complete markets, where the expected forex returns are a function of consumption growth variances and equity VRPs.

Keywords: Global Variance Risk Premium; Excess Foreign Exchange (Forex) Return; Complete Markets; Predictability.