Systematic Currency Volatility Risk Premia
66 Pages Posted: 13 May 2018
Date Written: April 20, 2018
I show that volatility risk of the dollar factor --- an equally weighted basket of developed U.S. dollar exchange rates --- carries a significant risk premium and that it is priced in the cross-section of currency volatility excess returns. The dollar factor volatility risk premium is negative on average with an upward sloping and concave term structure. Consistent with this pattern, I find that dollar factor volatility risk is most significantly priced in the cross-section of volatility excess returns at shorter maturities. A trading strategy that sells (buys) volatility insurance on currencies with high (low) exposure to dollar factor volatility risk delivers high mean excess returns and Sharpe ratios. At shorter maturities, the profitability of this strategy cannot be explained by exposure to traditional currency factors, equity factors, or currency volatility carry factors.
Keywords: Volatility Risk Premia, Factor Models, Foreign Exchange Volatility, Currency Options, Option-Implied Betas
JEL Classification: F31, F37, G01, G11, G12, G13, G15
Suggested Citation: Suggested Citation