Essays on FX variance risk premium, monetary policy and currency returns

Variance risk premium is arguably one of the most important and robust risk premia documented in the academic finance. The first chapter of this thesis deals with variance risk on the FX market: therein, I recover risk-neutralized covariance matrices of currency returns and combine them with ex post realized covariance matrices to determine the sign of the premium, associate portfolios ranked from highest to lowest premium values with popular currency factors, study the determinants of the FX variance risk and its explore asset pricing properties. I find evidence for an overall negative FX variance risk premium, but also document existence of strategies with a significantly positive one. Among portfolios with the most negative premium estimates, the US dollar index and Carry trade familiarly emerge. I report that portfolios of negative spot return momentum and high recently realized variance exhibit more negative FX variance risk premium. As far as the asset pricing properties are concerned, the Carry trade variance risk dominates the US dollar variance risk as a priced factor, contributing to resolution of the differential pricing of "good and bad'' carry portfolios. The second chapter studies the dynamics of currency spot and excess returns before policy rate announcements of central banks in developed economies. Therein, Dmitry Borisenko and I show that currencies depreciate before target rate cuts and appreciate before rate hikes. What makes the finding surprising is the fact that the fixed income derivatives market allows to forecast monetary policy decisions accurately enough to make the above drift exploitable by investors: our baseline specification of the trading strategy constructed by going long and short currencies before predicted local rate hikes and cuts earns a significant average return which would be only marginally higher if the forecast quality were perfect. In the third chapter, Nikola Mirkov, Paul Söderlind and I explore whether verbal interventions by the Swiss National Bank (SNB) affected market beliefs in the desired direction during the period from 2011 to 2015, when the SNB imposed a cap on the Swiss franc at 1.20 against the euro. We find that the speeches including the passionate “unlimited quantities” were followed by decreased forward-looking measures of uncertainty regarding the future value of euro/Swiss franc exchange rate and steered market beliefs toward franc depreciation, therefore reinforcing the credibility of the Swiss franc cap. In the fourth and final chapter, Dmitry Borisenko and I ponder over the power of overnight index swap (OIS) rates to forecast the path of future monetary policy. We first document no significant risk premium embedded in swap rates for maturities up to one year, which enables them to be unbiased predictors of future OIS underlying rates. Next, we extract the implied future policy target rates from the OIS prices to predict the outcome of monetary policy meetings around the world. In the US the OIS-implied forecasts outperform the federal funds futures-implied ones, and we report similarly high prediction accuracy for other developed countries.