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Title: Volatility Risk Premia and Exchange Rate Predictability

Author(s): Pasquale Della Corte, Tarun Ramadorai and Lucio Sarno

Publication Date: July 2013

Keyword(s): Exchange Rate, Hedgers, Order Flow, Predictability, Speculators and Volatility Risk Premium

Programme Area(s): Financial Economics and International Macroeconomics

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.

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Bibliographic Reference

Della Corte, P, Ramadorai, T and Sarno, L. 2013. 'Volatility Risk Premia and Exchange Rate Predictability'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=9549