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Journal of Financial Economics Vol. 120 No. 1 2016

Volatility risk premia and exchange rate predictability

Pasquale Della Corte; Tarun Ramadorai1,2; Lucio Sarno3,2

1 University of Oxford · 2 Centre for Economic Policy Research · 3 City, University of London

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 model-free implied volatility—reflects the costs of insuring against currency volatility fluctuations. 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 instead of interest rate differentials. We explore explanations for the profitability of the strategy, which cannot be understood using traditional risk factors.

DOI
10.1016/j.jfineco.2016.02.015
Volume
120
Issue
1
Pages
21-40
Language
en
Sources
bibtex:phds-export.bib openalex crossref

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