Volatility Risk Premia and Exchange Rate Predictability

Abstract

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.

Currency Premia and Global Imbalances

“…At the end of each month t, we form …ve currency portfolios using the 1-year implied volatility of currency option risk-reversals. For this exercise, we update the implied volatility of currency options quoted over-the-counter used by Della Corte, Ramadorai and Sarno (2015), who study the properties of this strategy in order to capture a skewness risk premium in FX markets. For each currency in each time period, we construct the 25-delta risk reversal, which is the implied volatility of an option strategy that buys a 25-delta out-of-the-money call and sells a 25-delta out-of-the-money put with 1-year maturity.…”

“…At the end of each period t, we group currencies into …ve portfolios using their 1-year volatility risk premium as described in Della Corte, Ramadorai and Sarno (2015). The volatility risk premium is de…ned as the di¤erence between the physical and the risk-neutral expectations of future realized volatility.…”

Retaining alpha: The effect of trade size and rebalancing frequency on FX strategy returns

“…In Subsection 4.2.1, we examine whether WM/R spreads overestimate the cost of trading, and we show that this is generally true for small trades, like $1 million, but not for larger trades. Many other studies have used WM/R spreads to proxy for transaction costs (e.g., Darvas, 2009;Banti et al, 2012;Della Corte et al, 2016;Maurer et al, 2019).…”

Does Option‐Implied Cross‐Sectional Return Dispersion Forecast Realized Cross‐Sectional Return Dispersion? Evidence From the G10 Currencies

“…Although the works of Nikolaou and Sarno (2006), Della Corte et al (2011), and Della Corte et al (2016 are important precursors to this paper, our empirical setting is different and more general, and thus resembles that used in an earlier study by Christensen and Prabhala (1998). We employed four different series of implied cross-sectional return dispersion for the G-10 currencies and regressed the realized return dispersion (RD) on the implied measures.…”