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Variance Risk Premiums in Foreign Exchange Markets

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  • Ammann, Manuel

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  • Buesser, Ralf

    ()

Abstract

Based on the theory of static replication of variance swaps we assess the sign and magnitude of variance risk premiums in foreign exchange markets. We find significantly negative risk premiums when realized variance is computed from intraday data with low frequency. As a likely consequence of microstructure effects however, the evidence is ambiguous when realized variance is based on high-frequency data. Common to all estimates, variance risk premiums are highly time-varying and inversely related to the risk-neutral expectation of future variance. When we test whether variance risk premiums can be attributed to classic risk factors or fear of jump risk, we find that conditional premiums remain significantly negative. However, we observe a strong relationship between the size of log variance risk premiums and the VIX, the TED spread and the general shape of the implied volatility function of the corresponding currency pair. Overall, we conclude that there is a separately priced variance risk factor which commands a highly time-varying premium.

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File URL: http://www1.vwa.unisg.ch/RePEc/usg/sfwpfi/WPF-1304.pdf
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Bibliographic Info

Paper provided by University of St. Gallen, School of Finance in its series Working Papers on Finance with number 1304.

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Length: 31 pages
Date of creation: Apr 2013
Date of revision:
Handle: RePEc:usg:sfwpfi:2013:04

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Keywords: Foreign exchange; variance risk premium; variance swap; intraday data; risk- neutral expectation; jump risk.;

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