Volatility Risk Premia and Exchange Rate Predictability

Della Corte, P., Ramadorai, T. & Sarno, L. (2016). Volatility Risk Premia and Exchange Rate Predictability. Journal of Financial Economics, 120(1), pp. 21-40. doi: 10.1016/j.jfineco.2016.02.015

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Abstract

We discover a new currency strategy with highly desirable return and diversification properties, which uses the predictive ability of currency volatility risk premia for currency returns. The volatility risk premium - the difference between expected realized volatility and modelfree implied volatility - reflects the costs of insuring against currency volatility fluctuations, and the strategy sells high-insurance-cost currencies and buys low-insurance-cost currencies. A distinctive feature of the strategy's returns is that they are mainly generated by movements in spot exchange rates rather than interest rate differentials. We explore explanations for the profitability of the strategy, which cannot be understood using traditional risk factors.

Item Type: Article
Additional Information: © 2016, Elsevier. Licensed under the Creative Commons Attribution-NonCommercial-NoDerivatives 4.0 International http://creativecommons.org/licenses/by-nc-nd/4.0/
Uncontrolled Keywords: Exchange Rates; Volatility Risk Premium; Predictability, Efficient Currency Portfolios
Subjects: H Social Sciences > HG Finance
Divisions: Cass Business School > Faculty of Finance
URI: http://openaccess.city.ac.uk/id/eprint/13156

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