Option-Implied Currency Risk Premia
79 Pages Posted: 13 Oct 2013 Last revised: 17 Oct 2014
Date Written: October 15, 2014
We obtain ex ante estimates of risk premia for G10 currency pairs using cross-sectional data on exchange rate options. Option prices are well-matched by a non-Gaussian, two-factor model, consistent with evidence from realized currency returns. We find that option-implied currency risk premia provide an unbiased forecast of monthly currency excess returns, and achieve cross-sectional forecasting R^2s of up to 44%. Despite prominent non-normalities in option data, less than 20% of the model HML-FX risk premium, or roughly 70bps per annum, is due to the asymmetries and higher-moments of global risks.
Keywords: risk premia, currency carry trade, disaster risk, exchange rate options
JEL Classification: F31, G12
Suggested Citation: Suggested Citation