Volatility Risk Premia and Exchange Rate Predictability

80 Pages Posted: 9 Jul 2013

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 2013

Abstract

We investigate the predictive information content in foreign exchange volatility risk premia for exchange rate returns. The volatility risk premium is the difference between realized volatility and a model-free measure of expected volatility that is derived from currency options, and reflects the cost of insurance against volatility ‡fluctuations in the underlying currency. We find that a portfolio that sells currencies with high insurance costs and buys currencies with low insurance costs generates sizeable out-of-sample returns and Sharpe ratios. These returns are almost entirely obtained via predictability of spot exchange rates rather than interest rate differentials, and these predictable spot returns are far stronger than those from carry trade and momentum strategies. Canonical risk factors cannot price the returns from this strategy, which can be understood, however, in terms of a simple mechanism with time-varying limits to arbitrage.

Keywords: Exchange Rate, Hedgers, Order Flow, Predictability, Speculators, Volatility Risk Premium

JEL Classification: F31, F37, G12, G13

Suggested Citation

Della Corte, Pasquale and Ramadorai, Tarun and Sarno, Lucio, Volatility Risk Premia and Exchange Rate Predictability (July 2013). CEPR Discussion Paper No. DP9549, Available at SSRN: https://ssrn.com/abstract=2291370

Pasquale Della Corte (Contact Author)

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

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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