No abstract

We show that a global imbalance risk factor that captures the spread in countries'external imbalances and their propensity to issue external liabilities in foreign currency explains the cross-sectional variation in currency excess returns. The economic intuition is simple: net debtor countries o¤er a currency risk premium to compensate investors willing to …nance negative external imbalances because their currencies depreciate in bad times. This mechanism is consistent with exchange rate theory based on capital ‡ows in imperfect …nancial markets. We also …nd that the global imbalance factor is priced in cross sections of other major asset markets.

We discover a new currency strategy with highly desirable return and diversi…cation properties, which uses the predictive capability of currency volatility risk premia for currency returns. The volatility risk premium -the di¤erence between expected realized volatility and model-free implied volatility -re ‡ects the costs of insuring against currency volatility ‡uctuations, and the strategy sells high-insurance-cost currencies and buys low-insurancecost currencies. The returns to the strategy are mainly generated by movements in spot exchange rates rather than interest rate di¤erentials, and the strategy carries a large weight in a minimum-variance portfolio of commonly employed currency strategies. We explore alternative explanations for the pro…tability of the strategy, which cannot be understood using traditional risk factors.

This is the unspecified version of the paper.This version of the publication may differ from the final published version. Abstract This paper investigates the empirical relation between spot and forward implied volatility in foreign exchange. We formulate and test the forward volatility unbiasedness hypothesis, which may be viewed as the volatility analogue to the extensively researched hypothesis of unbiasedness in forward exchange rates. Using a new data set of spot implied volatility quoted on over-thecounter currency options, we compute the forward implied volatility that corresponds to the delivery price of a forward contract on future spot implied volatility. This contract is known as a forward volatility agreement. We …nd strong evidence that forward implied volatility is a systematically biased predictor that overestimates movements in future spot implied volatility. This bias in forward volatility generates high economic value to an investor exploiting predictability in the returns to volatility speculation and indicates the presence of predictable volatility term premiums in foreign exchange. Permanent repository link