Expected currency returns and volatility risk premia

Abstract

This paper addresses the predictive ability of currency volatility risk premium – the difference between an implied and a realized volatility – over US dollar exchange rates using a time series perspective. The intuition is that, when risk aversion sentiment increases, the market quickly discounts the currency, and later this discount is accrued, leading to a future currency appreciation. Based on two different samples with a diversified set of 30 currencies, I document a positive relationship between currency volatility risk premium and future currency returns. Results remain robust even after controlling for traditional fundamental predictors like Purchase Power Parity and interest rate differential.