Volatility Risk Premia and Exchange Rate Predictability

71 Pages Posted: 16 Mar 2013 Last revised: 1 Jun 2015

See all articles by Pasquale Della Corte

Pasquale Della Corte

Imperial College Business School; Centre for Economic Policy Research (CEPR)

Tarun Ramadorai

Imperial College London; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

Lucio Sarno

University of Cambridge - Judge Business School; Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 2 versions of this paper

Date Written: July 29, 2014

Abstract

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 volatility 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 large weight in a minimum-variance portfolio of commonly employed currency strategies. We explore alternative explanations for the profitability of the strategy, which cannot be understood using traditional risk factors.

Keywords: Exchange Rates, Volatility Risk Premium, Predictability, Minimum-Variance Currency Portfolio

JEL Classification: F31, G12, G13

Suggested Citation

Della Corte, Pasquale and Ramadorai, Tarun and Sarno, Lucio, Volatility Risk Premia and Exchange Rate Predictability (July 29, 2014). Journal of Financial Economics (JFE), Forthcoming, Available at SSRN: https://ssrn.com/abstract=2233367 or http://dx.doi.org/10.2139/ssrn.2233367

Pasquale Della Corte

Imperial College Business School ( email )

South Kensington Campus
Exhibition Road
London, SW7 2AZ
United Kingdom
+44(0)20 759 49331 (Phone)

HOME PAGE: http://sites.google.com/view/pasqualedellacorte

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Tarun Ramadorai (Contact Author)

Imperial College London ( email )

South Kensington Campus
Exhibition Road
London, Greater London SW7 2AZ
United Kingdom

HOME PAGE: http://www.tarunramadorai.com

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

Lucio Sarno

University of Cambridge - Judge Business School ( email )

Trumpington Street
Cambridge, CB2 1AG
United Kingdom

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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