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Volatility Risk Premia and Exchange Rate Predictability

Last Updated on 10 February, 2024 by Rejaul Karim

The research paper “Volatility Risk Premia and Exchange Rate Predictability” authored by Pasquale Della Corte, Tarun Ramadorai, and Lucio Sarno offers intricate insights into a novel currency strategy with exceptionally appealing return and diversification properties.

This innovative strategy capitalizes on the predictive capacity of currency volatility risk premia for currency returns, harnessing the volatility risk premium, denoting the variance between expected realized volatility and model-free implied volatility.

The strategy entails selling high-insurance-cost currencies while purchasing low-insurance-cost currencies, yielding returns primarily driven by fluctuations in spot exchange rates rather than interest rate differentials.

Notably, the strategy assumes a substantial weight in a minimum-variance portfolio encompassing commonly employed currency strategies, further amplifying its significance. The study delves into alternative explanations for the strategy’s profitability, which eludes comprehension using traditional risk factors.

This in-depth analysis unveils the strategy’s potential and enriches our understanding of exchange rate predictability, illuminating a promising avenue for enhancing returns and diversification in the realm of currency strategies.

Abstract Of Paper

We discover a new currency strategy with highly desirable return and diversification properties, which uses the predictive capability 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, and the strategy sells high-insurance-cost currencies and buys low-insurance-cost currencies. The returns to the strategy are mainly generated by movements in spot exchange rates rather than interest rate differentials, and the strategy carries a large weight in a minimum-variance portfolio of commonly employed currency strategies. We explore alternative explanations for the profitability of the strategy, which cannot be understood using traditional risk factors.

Original paper – Download PDF

Here you can download the PDF and original paper of Volatility Risk Premia and Exchange Rate Predictability.

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Author

Pasquale Della Corte
Imperial College Business School; Centre for Economic Policy Research (CEPR)

Tarun Ramadorai
Imperial College London; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

Lucio Sarno
University of Cambridge – Judge Business School; Centre for Economic Policy Research (CEPR)

Conclusion

In conclusion, the research paper “Volatility Risk Premia and Exchange Rate Predictability” authored by Pasquale Della Corte, Tarun Ramadorai, and Lucio Sarno accentuates the profound significance of a pioneering currency strategy renowned for its exceptional return and diversification characteristics.

The strategy, which harnesses the predictive power of currency volatility risk premia for currency returns, capitalizes on the variance between expected realized volatility and model-free implied volatility. Operating by selling high-insurance-cost currencies and acquiring low-insurance-cost currencies, the strategy predominantly derives returns from spot exchange rate fluctuations rather than interest rate differentials, warranting a noteworthy allocation in a minimum-variance portfolio of conventional currency strategies.

The research propounds alternative explanations for the strategy’s profitability, reframing the discourse on currency strategies and exchange rate predictability. This compelling analysis enriches our comprehension of exchange rate predictability and underscores the strategy’s potential for maximizing returns and diversification within the domain of currency strategies.

Related Reading:

Is There Momentum or Reversal in Weekly Currency Returns?

Currency Strategies and Sovereign Ratings

FAQ

Q1: What is the focus of the research paper “Volatility Risk Premia and Exchange Rate Predictability”?

A1: The research paper focuses on a novel currency strategy that capitalizes on the predictive capacity of currency volatility risk premia for currency returns. The strategy involves selling high-insurance-cost currencies and buying low-insurance-cost currencies, aiming to generate returns primarily from fluctuations in spot exchange rates rather than interest rate differentials.

Q2: What does the term “volatility risk premia” refer to in the context of the paper?

A2: The term “volatility risk premia” in this context refers to the difference between expected realized volatility (the actual volatility of currency returns) and model-free implied volatility (implied volatility derived from option prices). The strategy exploits this difference, representing the costs of insuring against currency volatility fluctuations.

Q3: What is notable about the returns generated by the strategy mentioned in the paper?

A3: The returns to the strategy are mainly driven by movements in spot exchange rates rather than interest rate differentials. This is a notable characteristic as it distinguishes the strategy’s source of returns from traditional currency strategies.

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