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Volatility Risk Premia and Exchange Rate Predictability

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

Pasquale Della Corte

Imperial College London; Centre for Economic Policy Research (CEPR)

Tarun Ramadorai

Imperial College London; Centre for Economic Policy Research (CEPR)

Lucio Sarno

City University London - Sir John Cass 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 London ( email )

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

HOME PAGE: http://https://sites.google.com/site/pasqualedellacorte/

Centre for Economic Policy Research (CEPR) ( email )

77 Bastwick Street
London, EC1V 3PZ
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 )

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

Lucio Sarno

City University London - Sir John Cass Business School ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom

Centre for Economic Policy Research (CEPR)

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

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