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Variance risk premiums and the forward premium puzzle

  • Juan M. Londono
  • Hao Zhou
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This paper presents evidence that the foreign exchange appreciation is predictable by the currency variance risk premium at a medium 6-month horizon and by the stock variance risk premium at a short 1-month horizon. Although currency variance risk premiums are highly correlated with each other over longer horizons, their correlations with stock variance risk premiums are quite low. Interestingly the currency variance risk premium has no predictive power for stock returns. We rationalize these findings in a consumption-based asset pricing model with orthogonal local and global economic uncertainties. In our model the market is incomplete in the sense that the global uncertainty is not priced by local stock markets and is therefore a forex-specific phenomenon—the currency uncertainty’s effects on the expected stock return are off-setting between the cash flow channel and the volatility channel.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 1068.

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Date of creation: 2012
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Handle: RePEc:fip:fedgif:1068
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  8. Guo, Dajiang, 1998. "The Risk Premium of Volatility Implicit in Currency Options," Journal of Business & Economic Statistics, American Statistical Association, vol. 16(4), pages 498-507, October.
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  12. Bollerslev, Tim & Marrone, James & Xu, Lai & Zhou, Hao, 2014. "Stock Return Predictability and Variance Risk Premia: Statistical Inference and International Evidence," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 49(03), pages 633-661, June.
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  16. Della Corte, Pasquale & Sarno, Lucio & Tsiakas, Ilias, 2011. "Spot and forward volatility in foreign exchange," Journal of Financial Economics, Elsevier, vol. 100(3), pages 496-513, June.
  17. Itamar Drechsler & Amir Yaron, 2011. "What's Vol Got to Do with It," Review of Financial Studies, Society for Financial Studies, vol. 24(1), pages 1-45.
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  20. Baillie, Richard T & Bollerslev, Tim, 2002. "The Message in Daily Exchange Rates: A Conditional-Variance Tale," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(1), pages 60-68, January.
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  23. Arash, Aloosh, 2011. "Variance Risk Premium Differentials and Foreign Exchange Returns," MPRA Paper 40829, University Library of Munich, Germany, revised 18 Aug 2012.
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