Volatility Risk Premia and Exchange Rate Predictability

We discover a new currency strategy with highly desirable return and diversification properties, which uses the predictive capability of currency volatility risk premia for currency returns. The volatility risk premium -- the difference between expected realized volatility and model-free implied volatility -- reflects the costs of insuring against currency volatility fluctuations, and the strategy sells high-insurance-cost currencies and buys low-insurance-cost currencies. The returns to the strategy are mainly generated by movements in spot exchange rates rather than interest rate differentials, and the strategy carries a large weight in a minimum-variance portfolio of commonly employed currency strategies. We explore alternative explanations for the profitability of the strategy, which cannot be understood using traditional risk factors