Variance risk premium and expected currency return: the story is different at the tails of the distribution

ABSTRACT

This paper investigates the prediction power of variance risk premium of domestic currency over the currency return for five major emerging market currencies controlling after the impact of past exchange rate developments and asymmetries in the variance risk premium, and the dependence between variance risk premium and currency return at different quantiles. The OLS regression results show that higher (lower) variance risk premium leads appreciation (depreciation) of domestic currency against US Dollar and this relationship holds in after controlling asymmetries in the variance risk premium and past currency returns. Besides, the results don’t confirm an asymmetric effect of the variance risk premium and a linearly increasing effect of variance risk premium conditional on different quantiles of past currency return. Finally, quantile-on-quantile regression (QQR) results show that the negative association of variance risk premium and currency return reverse to be positive at the tails.

KEYWORDS:

• Variance risk premium
• exchange rates
• quantile-on-quantile regression

Disclosure statement

No potential conflict of interest was reported by the author.

Notes

1. BIS Triennial Central Bank Survey of Foreign Exchange and Over-the-counter (OTC) Derivatives Markets (2019) reports that Brazilian Real, Mexican Peso, South African Rand, Indian Rupee, Turkish Lira, Hungarian Forint, Russian Ruble and Polish Zloty are the currencies owning highest turnover volume of options market in a sequence among Emerging Market currencies. We excluded Hungarian Forint, Russian Ruble and Polish Zloty because the flexibility of these currencies had been limited during the subperiods of the sample period of this study (January 2007 to December 2018).