From Macroeconomic Uncertainty to FX Returns: The Role of Realized Volatility in Shaping Risk‐Return Dynamics

The paper proposes a theoretical model with variance‐belief formation to investigate the relationship among macroeconomic uncertainty (abbreviated as MU), the conditional variance of the exchange rate, and exchange rate returns. The model posits a weak, even negative, intertemporal and negative contemporaneous risk‐return or MU‐return relationship if agents possess biased, slow‐moving expectations. The empirical study, which utilizes multi‐currency data, corroborates the negative risk‐return relationship. However, the significance of the MU‐return relationship is contingent upon the extent to which the MU proxy captures the uncertainty surrounding economic fundamentals associated with exchange rates comprehensively. In summary, this study offers more insight into the role of fundamentals in exchange rate movements and the risk‐return relationship in FX markets with a focus on MU.