Global Currency Variance Risk and Currency Return Predictability

Abstract

We construct global currency variance risk indices as the equal-weighted average of currency option-implied or realized variance across 17 major currencies, and find that they significantly and positively predict currency returns, especially for horizons beyond one month. The in-sample adjusted R2 statistics are 0.92%–5.08% for global currency option-implied variance and 0.95%–7.48% for global currency realized variance. They perform well for out-of-sample cases, with R2 statistics of 0%–6.43% for global currency option-implied variance and −0.25%–9.94% for global currency realized variance. Additionally, global currency variance risk is closely related to U.S. economic activity, uncertainty, the VIX, and sentiment.

Keywords: global currency variance risk, currency returns, predictive regressions, out-of-sample tests, economic activity

JEL Classification: G12, G15, F31