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Volatility risk premia and exchange rate predictability

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Title: Volatility risk premia and exchange rate predictability
Authors: Della Corte, P
Ramadorai, T
Sarno, L
Item Type: Journal Article
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.
Issue Date: 26-Feb-2016
Date of Acceptance: 2-Dec-2014
URI: http://hdl.handle.net/10044/1/39815
DOI: https://dx.doi.org/10.1016/j.jfineco.2016.02.015
ISSN: 0304-405X
Publisher: Elsevier
Start Page: 21
End Page: 40
Journal / Book Title: Journal of Financial Economics
Volume: 120
Issue: 1
Copyright Statement: © 2016, Elsevier. Licensed under the Creative Commons Attribution-NonCommercial-NoDerivatives 4.0 International http://creativecommons.org/licenses/by-nc-nd/4.0/
Keywords: Social Sciences
Business, Finance
Economics
Business & Economics
Exchange rates
Volatility risk premium
Predictability
Efficient currency portfolios
CONSISTENT COVARIANCE-MATRIX
CONSUMPTION GROWTH RISK
FOREIGN-CURRENCY RISK
CROSS-SECTION
OPTION PRICES
HEDGE FUNDS
RETURNS
MARKETS
ARBITRAGE
MODELS
Finance
1502 Banking, Finance And Investment
Publication Status: Published
Open Access location: http://ssrn.com/abstract=2233367
Appears in Collections:Imperial College Business School