The Cross-Section of Currency Volatility Premia

Abstract

We identify a global risk factor that drives the cross-section of volatility excess returns in the foreign exchange market. We show that a zero-cost strategy that buys forward volatility agreements with downward sloping volatility curves and sells those with upward slopes - the volatility carry strategy - earns on average 5.15% per month. When we form slope-sorted portfolios, the covariation with volatility carry returns fully explains the cross-sectional variation of our portfolios. The lower the slope of the volatility curve, the more the forward volatility agreement is exposed to volatility carry risk. A standard no-arbitrage model of exchange rates with two types of factor - a set of country specifi c factors and a global one - provides intuition for the findings. The state variables determining the exposure to the global risk factor are empirically related to squared deviations of changes in economic growth. In the cross-section, the returns to volatility carry strategy are only weakly related to traditional currency risk factors, like carry, global imbalance, global volatility and global liquidity risk.