Working Paper: CEPR ID: DP9549
Authors: Pasquale Della Corte; Tarun Ramadorai; Lucio Sarno
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 Codes: F31; F37; G12; G13
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| limits to arbitrage (G19) | demand for volatility insurance (G52) |
| demand for volatility insurance (G52) | predictable currency movements (F31) |
| high volatility risk premium (VRP) (G17) | long on currencies (F31) |
| low volatility risk premium (VRP) (G17) | short on currencies (F31) |
| predictability of spot exchange rates (F31) | returns from VRP strategy (G11) |
| canonical risk factors (I12) | inadequately price returns from VRP strategy (G11) |
| volatility risk premium (VRP) (G17) | future spot exchange rate returns (F31) |