Variance Risk Premiums and the Forward Premium Puzzle

54 Pages Posted: 7 Feb 2013

See all articles by Juan M. Londono

Juan M. Londono

Board of Governors of the Federal Reserve System

Hao Zhou

Tsinghua University - PBC School of Finance; SUSTech Business School

Multiple version iconThere are 3 versions of this paper

Date Written: December 2012

Abstract

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.

Keywords: forward premium puzzle, currency variance risk premium, stock variance, risk premium, unspanned currency uncertainty, forex return predictability

JEL Classification: G12, G15, F31

Suggested Citation

Londono-Yarce, Juan-Miguel and Zhou, Hao, Variance Risk Premiums and the Forward Premium Puzzle (December 2012). FRB International Finance Discussion Paper No. 1068, Available at SSRN: https://ssrn.com/abstract=2209753 or http://dx.doi.org/10.2139/ssrn.2209753

Juan-Miguel Londono-Yarce (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Hao Zhou

Tsinghua University - PBC School of Finance ( email )

No. 43, Chengfu Road
Haidian District
Beijing, 100083
China
+86-10-62790655 (Phone)

SUSTech Business School ( email )

1088 Xueyuan Avenue, Nanshan District
Southern University of Science and Technology
Shenzhen, Guangdong 518055
China

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