The Conditional Volatility Premium on Currency Portfolios

Our paper examines conditional risk-return relations in a cross-section of currency portfolios, while modeling economic states using a large number of underlying risk factors. We identify a time-varying relationship between currency returns and volatility risk: investors require a positive risk premium in many, but by no means all, time periods or investment strategies. We find that value and momentum portfolios obtained a positive risk premium during the financial crisis. Important economic states underpinning exchange rate risks include the US and global business cycles. Finally, we uncover that the risk-return relation on the momentum portfolio is counter-cyclical.