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Volatility Risk Premia and Exchange Rate Predictability y

Pasquale DELLA CORTE Tarun RAMADORAI Lucio SARNO

July 2013

Abstract
We investigate the predictive information content in foreign exchange volatility risk
premia for exchange rate returns. The volatility risk premium is the di¤erence between
realized volatility and a model-free measure of expected volatility that is derived from
currency options, and re‡ects the cost of insurance against volatility ‡uctuations in the
underlying currency. We …nd that a portfolio that sells currencies with high insurance
costs and buys currencies with low insurance costs generates sizeable out-of-sample re-
turns and Sharpe ratios. These returns are almost entirely obtained via predictability
of spot exchange rates rather than interest rate di¤erentials, and these predictable spot
returns are far stronger than those from carry trade and momentum strategies. Canon-
ical risk factors cannot price the returns from this strategy, which can be understood,
however, in terms of a simple mechanism with time-varying limits to arbitrage.

Keywords: Exchange Rates; Volatility Risk Premium; Predictability.


JEL Classi…cation: F31; F37.

Acknowledgements: We are grateful to John Campbell, Kenneth Froot, Philippos Kassimatis, Lars
Lochstoer, Andrea Vedolin and Adrien Verdelhan for helpful conversations and suggestions. We also thank
JP Morgan and Aslan Uddin for some of the data used in this study. Sarno acknowledges …nancial support
from the Economic and Social Research Council (No. RES-062-23-2340). All errors remain ours.
y
Pasquale Della Corte is with Imperial College Business School, Imperial College London; email:
p.dellacorte@imperial.ac.uk. Tarun Ramadorai is with the Saïd Business School, Oxford-Man Insti-
tute, University of Oxford and CEPR; email: tarun.ramadorai@sbs.ox.ac.uk. Lucio Sarno is with Cass
Business School, City University London and CEPR; email: lucio.sarno@city.ac.uk.
1 Introduction
What explains currency ‡uctuations? Finance practitioners and academics have struggled in
vain with this question for decades. In their seminal study, Meese and Rogo¤ (1983) highlight
the di¢ culty of explaining and predicting short-run currency movements, by documenting that
it is …endishly di¢ cult to …nd theoretically motivated variables able to beat a random walk
forecasting model for currencies. The literature has found it di¢ cult to move far ahead of this
result in the past three decades (see, for example, Rogo¤ and Stavrakeva, 2008, and Engel,
Mark and West, 2008).
A research area which has recently seen signi…cant activity tackles a closely-related ques-
tion, which is to explain the returns to currency investment strategies. Adopting the cross-
sectional asset pricing approach of constructing portfolios sorted by currency characteristics
such as interest rate di¤erentials or lagged returns, researchers have shown that there are large
returns to carry and momentum strategies in currencies.1 These recent …ndings do not help
to resolve the Meese and Rogo¤ puzzle, and exacerbate it somewhat, in the sense that they
reveal economically signi…cant predictability in currency excess returns, but they have little
to say about predictability in spot exchange rates.2 On the one hand, carry trade strategies
generate returns that are almost entirely driven by interest rate di¤erentials, and not by any
predictive ability for spot rate changes. On the other hand, while it is true that momen-
tum strategies generate returns that are primarily driven by the predictability of spot rate
changes rather than by interest rate di¤erentials, these strategies appear to work poorly over
the last decade for liquid currencies, and they are di¢ cult to exploit in practice (Menkho¤,
Sarno, Schmeling and Schrimpf, 2012b). Moreover, momentum strategies do not provide
much insight into the underlying economic drivers of exchange rate movements, or the source
of exchange rate predictability.
In this paper we investigate the predictive information content in the currency volatility

1
See, for example, Lustig and Verdelhan (2007), Ang and Chen (2010), Burnside, Eichenbaum, Kleshchelski
and Rebelo (2011), Lustig, Roussanov and Verdelhan (2001), Barroso and Santa Clara (2012) and Menkho¤,
Sarno, Schmeling and Schrimpf (2012a,b), who all build currency portfolios to study return predictability
and/or currency risk exposure.
2
We use interchangeably the terms spot returns and exchange rate returns to de…ne the change in nominal
exchange rates over time; similarly we use interchangeably the terms excess returns or portfolio returns to
refer to the returns from implementing a long-short currency trading strategy that buys and sells currencies
on the basis of some characteristic.

1
risk premium for exchange rate returns. Our key result is that there is economically valuable
and statistically signi…cant predictive information in the volatility risk premium for future spot
exchange rate returns over the 1996 to 2011 period, in a cross-section of up to 20 currencies.3
We consider two main explanations for our results, and …nd support for an explanation based
on limits to arbitrage and the interaction between hedgers and speculators in the currency
market. This explanation is consistent with the growing theoretical and empirical literature
suggesting that such interactions are important in asset return determination (see, for example,
Acharya, Lochstoer, and Ramadorai; 2013, Adrian, Etula, and Muir, 2013; and Gromb and
Vayanos, 2010 for an excellent survey of the literature).
The currency volatility risk premium is the di¤erence between expected future realized
volatility, and a model-free measure of expected volatility derived from currency options. A
growing literature studies the variance or the volatility risk premium in di¤erent asset classes,
including equity, bond, and foreign exchange (FX) markets.4 In general, this literature has
shown that the volatility risk premium is on average negative –expected volatility is higher
than historical realized volatility, and since volatility is persistent, expected volatility is also
generally higher than future realized volatility. In other words, the volatility risk premium
represents compensation for providing volatility insurance. Therefore, akin to the interpreta-
tion in Garleanu, Pedersen, and Poteshman (2009), the currency volatility risk premium that
we construct can be interpreted as the cost of insurance against volatility ‡uctuations in the
underlying currency – when it is high (realized volatility is higher than the option-implied
volatility), insurance is relatively cheap, and vice versa.
We use the currency volatility risk premium to rank currencies and to build currency
portfolios, sorting currencies into quintile portfolios by this variable at the beginning of each
month. Our trading strategy is to buy currencies with relatively cheap volatility insurance,
i.e., the highest volatility risk premium quintile, and short currencies with relatively expensive
volatility insurance, i.e., the lowest volatility risk premium quintile. We track returns on this
trading strategy, which we dub V RP , over the subsequent period, meaning that these returns
3
To be clear from the outset, our strategy does not trade volatility products. We simply use the expected
volatility risk premium as conditioning information to sort currencies, build currency portfolios, and uncover
predictability in spot exchange rate returns.
4
See, for example, Carr and Wu (2009), Eraker (2008), Bollerslev, Tauchen, and Zhou (2009), Todorov
(2010), Drechsler and Yaron (2010), Han and Zhou (2010), Mueller, Vedolin and Yen (2011), Londono and
Zhou (2012) and Buraschi, Trojani and Vedolin (2013).

2
are purely out-of-sample, conditioning only on information available at the time of portfolio
construction.
We …nd that V RP generates sizeable currency excess returns, which are virtually com-
pletely obtained through prediction of spot exchange rates rather than from interest rate
di¤erentials. That is, currencies with relatively cheap volatility insurance tend to appreciate
over the subsequent month, while those with relatively more expensive volatility insurance
tend to depreciate over the next month. The observed predictability of spot exchange rates
associated with V RP is far stronger than that arising from carry and momentum strategies,
as well as other currency trading strategies that we consider.
There are several possible interpretations of this result, of which we consider two as most
likely. One possibility is that V RP captures ‡uctuations in aversion to volatility risk, in
which currencies with high volatility insurance have low expected returns and vice versa.
Note that our result is cross-sectional, since we are long and short currencies simultaneously.
As a result, if this explanation were true, it would rely either on di¤erent currencies loading
di¤erently on a global volatility shock, or indeed on market segmentation causing expected
returns on di¤erent currencies to be determined independently. We test this explanation
both using cross-sectional asset pricing tests of volatility risk premium-sorted portfolios on a
global FX volatility risk portfolio, as well as by estimating the loadings of currency returns
on various proxies for global volatility risk and building portfolios sorted on these estimated
loadings. Neither of these tests produces evidence consistent with the proposed explanation,
with the long-short strategy generated from estimated loadings on the global volatility risk
factor producing far inferior returns to V RP , which are also virtually uncorrelated with V RP
returns. In sum, the data appear to reject an explanation based on ‡uctuations in aversion
to global volatility risk.
The second explanation that we consider for our results relies on a framework that has
gained importance in the recent literature on limits to arbitrage and the incentives of hedgers
and speculators in asset markets (see, for example, Acharya, Lochstoer, and Ramadorai,
2013). This explanation relies on two ingredients, the …rst of which is time-variation in
the amount of arbitrage capital available to natural providers of currency volatility insurance
(“speculators”), such as …nancial institutions or hedge funds. The second ingredient is that
risk-averse natural “hedgers”of currencies such as multinational …rms, or …nancial institutions

3
that inherit currency positions from their clients, are more willing to hold currencies for which
volatility insurance is relatively inexpensive. Such institutions will also be more likely to avoid
holding, or be more likely to sell, positions in currencies with relatively expensive volatility
protection. The combination of these two ingredients is su¢ cient to generate the patterns
that we see in the data.
To better understand this explanation, consider the following scenario: assume that spec-
ulators face a shock to their available arbitrage capital. This limits their ability to provide
cheap volatility insurance –for example, they may reduce their outstanding short put option
positions in the currencies in which they trade.5 These limits on speculators’ability to satisfy
demand for volatility insurance increases net demand in the options market, thus increasing
current option prices and making hedging more expensive. As in Garleanu, Pedersen, and
Poteshman (2009), this net demand imbalance shows up in a lower volatility risk premium for
the currencies thus a¤ected. Given the high cost of volatility insurance, natural hedgers scale
back on the amount of spot currency they are willing to hold. As this currency hits the spot
market, it will predictably depress spot prices, leading to relatively low returns on the spot
currency position. When capital constraints loosen, we should see the opposite behavior, i.e.,
a reversal in both the volatility risk premium and the spot currency position.
In the cross-section of currencies, this mechanism implies that, in a world with limited and
time-varying arbitrage capital, an institution wishing to hedge against risk (or deleveraging) in
one currency position rather than another will generate excess demand for volatility insurance
for the currency to which it is more exposed, in turn increasing the spread in volatility risk
premia across currencies.
This explanation for our baseline result has additional testable implications. Most obvi-
ously, the explanation implies that the returns from the V RP strategy, post-formation, should
be temporary, i.e., there should be reversion in currency returns once arbitrage capital returns
to the market. Con…rming this prediction, we …nd that currency volatility risk-premium
sorted portfolio returns reverse over a holding period of a few months. Moreover, at times
when funding liquidity is lower (i.e., times of high capital constraints on speculators), and

5
Short put options is a favoured strategy of many hedge funds; see Agarwal and Naik (2004), for example.
Also see Fung and Hsieh (1997) for how lookback options can be used to capture the returns to momentum
trading strategies implemented by hedge funds.

4
demand for volatility protection is higher (i.e., times of increased risk aversion of natural
hedgers), we should …nd that the spread in the cost of volatility insurance across currencies,
and the spread in spot exchange rate returns across portfolios should both increase. In our
empirical analysis, we …nd that when the TED spread –a commonly used proxy for funding
liquidity (see, for example, Garleanu and Pedersen, 2011) – increases, the returns on V RP
are substantially higher. Fluctuations in risk aversion, as proxied by changes in the VIX,
are also useful in explaining our returns, and add signi…cant additional explanatory power
when interacted with the TED spread. We also measure capital ‡ows to currency and global
macro hedge funds, and …nd that when hedge fund ‡ows are high, signifying increased funding
and thus lower hedge fund capital constraints, the returns to V RP are lower and vice versa,
providing useful evidence in support of the limits to arbitrage explanation.
We also obtain more direct evidence in favour of the limits to arbitrage explanation when
we investigate the behavior of currency order ‡ow in our insurance-cost sorted portfolios.
This evidence links our work to another important stream of the exchange rate literature, on
explaining and forecasting currency returns using currency order ‡ow.6 Our paper suggests
an addition to the explanations that have been advanced to explain this predictive power,
namely that incentives to hedge volatility risk may be a contributing factor to the observed
predictive relationship. We document that V RP is connected to measures of customer order
‡ow in a way that is consistent with the proposed explanation. Speci…cally when we investigate
the behavior of net order ‡ow in our volatility risk-premium sorted portfolios, we …nd that
end-customers who are corporate clients tend to buy currencies which are cheaper to insure,
and sell currencies which are more expensive to insure in the spot currency market. Asset
managers, on the other hand, appear to satisfy demand for spot currencies at such times,
trading in a way that is exactly opposite to that of corporate clients. Hedge funds appear to
exacerbate the level of price pressure, trading in the same direction as corporate clients in the
spot market. This analysis using observed currency order ‡ows in the spot market serves to
corroborate our other evidence suggesting that V RP returns are driven by the interaction of
natural hedgers and speculators in currency markets.
6
Evans and Lyons (2002) show that currency order ‡ow has substantial explanatory power for contempo-
raneous exchange rate returns, and authors such as Froot and Ramadorai (2005), Evans and Lyons (2005),
and more recently, Menkho¤, Sarno, Schmeling and Schrimpf (2013), show that order ‡ow has substantial
predictive power for exchange rate movements.

5
The paper is structured as follows. Section 2 de…nes the volatility risk premium and
its measurement in currency markets. Section 3 describes our data and some descriptive
statistics. Section 4 presents our main empirical results on the volatility risk premium-sorted
strategy, Section 5 reports formal asset pricing tests, while Section 6 investigates two alterna-
tive mechanisms that could explain our …ndings. Section 7 concludes. A separate Internet
Appendix provides robustness tests and additional supporting analyses.

2 Foreign Exchange Volatility Risk Premia


Volatility Swap. A volatility swap is a forward contract on the volatility “realized”on the
underlying asset over the life of the contract. The buyer of a volatility swap written at time
t, and maturing at time t + , receives the payo¤ (per unit of notional amount):

V Pt; = (RVt; SWt; ) (1)

where RVt; is the realized volatility of the underlying, SWt; is the volatility swap rate, and
both RVt; and SWt; are de…ned over the life of the contract from time t to time t + , and
quoted in annual terms. However, while the realized volatility is determined at the maturity
date t + , the swap rate is agreed at the start date t.
The value of a volatility swap contract is obtained as the expected present value of the
future payo¤ in a risk-neutral world. This implies, because V Pt; is expected to be 0 under
the risk-neutral measure, that the volatility swap rate equals the risk-neutral expectation of
the realized volatility over the life of the contract:

SWt; = EtQ [RVt; ] (2)


q R t+
where EtQ [ ] is the expectation under the risk-neutral measure Q, RVt; = 1
t
2 ds,
s
2
and s denotes the (stochastic) volatility of the underlying asset.

Volatility Swap Rate. We synthesize the volatility swap rate using the model-free
approach derived by Britten-Jones and Neuberger (2000), and further re…ned by Demeter…,
Derman, Kamal and Zou (1999), Jiang and Tian (2005), and Carr and Wu (2009).
Building on the pioneering work of Breeden and Litzenberger (1978), Britten-Jones and
Neuberger (2000) derive the model-free implied volatility entirely from no-arbitrage conditions

6
and without using any speci…c option pricing model. Speci…cally, they show that the risk-
neutral expected integrated return variance between the current date and a future date is fully
speci…ed by the set of prices of call options expiring on the future date, provided that the
price of the underlying evolves continuously with constant or stochastic volatility but without
jumps.
Demeter…, Derman, Kamal, and Zou (1999) show that the Britten-Jones and Neuberger
(2000) solution is equivalent to a portfolio that combines a dynamically rebalanced long po-
sition in the underlying, and a static short position in a portfolio of options and a forward
that together replicate the payo¤ of a “log contract.”7 The replicating portfolio strategy cap-
tures variance exactly, provided that the portfolio of options contains all strikes with the
appropriate weights to match the log payo¤. Jiang and Tian (2005) further demonstrate that
the model-free implied variance is valid even when the underlying price exhibits jumps, thus
relaxing the di¤usion assumptions of Britten-Jones and Neuberger (2000).
The risk-neutral expectation of the return variance between two dates t and t + can be
formally computed by integrating option prices expiring on these dates over an in…nite range
of strike prices:
Z Z !
Ft; 1
1 1
EtQ RVt;2 = Pt; (K)dK + Ct; (K)dK (3)
0 K2 Ft; K2

where Pt; (K) and Ct; (K) are the put and call prices at t with strike price K and maturity
date t + , Ft; is the forward price matching the maturity date of the options, St is the price
of the underlying, = (2= ) exp (it; ), and it; is the -period domestic riskless rate.
The risk-neutral expectation of the return variance in Equation (3) delivers the strike price
of a variance swap EtQ RVt;2 , and is referred to as the model-free implied variance. Even
though variance emerges naturally from a portfolio of options, it is volatility that participants
prefer to quote. Our empirical analysis focuses on volatility swaps, and we synthetically
construct the strike price of this contract as
q
EtQ [RVt; ] = EtQ RVt;2 (4)

and refer to it as model-free implied volatility.


7
The log contract is an option whose payo¤ is proportional to the log of the underlying at expiration
(Neuberger, 1994).

7
While straightforward, this approach is subject to a convexity bias. The main complication
in valuing volatility swaps arises from the fact that the strike of a volatility swap is not
equal to the square root of the strike of a variance swap due to Jensen’s inequality, i.e.,
q
Q
Et [RVt; ] EtQ RVt;2 . The convexity bias that arises from the above inequality leads
to imperfect replication when a volatility swap is replicated using a buy-and-hold strategy of
variance swaps (e.g., Broadie and Jain, 2008). Simply put, the payo¤ of variance swaps is
quadratic with respect to volatility, whereas the payo¤ of volatility swaps is linear.
We deal with this bias in approximation in two ways. First, we measure the convexity
bias using a second-order Taylor expansion as in Brockhaus and Long (2000) and …nd that
it is empirically small.8 More importantly, when we re-do our empirical exercise with model-
free implied variances, we …nd virtually identical results. Hence the convexity bias has no
discernible e¤ect on our results and the approximation in Equation (4) works well in our
framework, which explains why it is widely used by practitioners (e.g., Knauf, 2003).
Computing model-free implied volatility requires the existence of a continuum in the cross-
section of option prices at time t with maturity date . In the FX market, over-the-counter
options are quoted in terms of Garman and Kohlhagen (1983) implied volatilities at …xed
deltas. Liquidity is generally spread across …ve levels of deltas. From these quotes, we extract
…ve strike prices corresponding to …ve plain vanilla options, and follow Jiang and Tian (2005),
who present a simple method to implement the model-free approach when option prices are
only available on a …nite number of strikes.
Speci…cally, we use a cubic spline around these …ve implied volatility points. This inter-
polation method is standard in the literature (e.g., Bates, 1991; Campa, Chang and Reider,
1998; Jiang and Tian, 2005; Della Corte, Sarno and Tsiakas, 2011) and has the advantage
that the implied volatility smile is smooth between the maximum and minimum available
strikes, beyond which we extrapolate implied volatility by assuming it is constant as in Jiang
and Tian (2005) and Carr and Wu (2009). We then compute the option values using the
Garman and Kohlhagen (1983) valuation formula,9 and use trapezoidal integration to solve
q
V2
8
Brockhaus and Long (2000) show that EtQ [RVt; ] = EtQ RVt;2 8m3=2
where m and V 2 denote the
mean and variance of the future realized
q variance, respectively, under the risk-neutral measure Q. EtQ [RVt; ]
is certainly less than or equal to EtQ RVt;2 due to the Jensen’s inequality, and V 2 =8m3=2 measures the
convexity error.
9
This valuation formula can be thought of as the Black and Scholes (1973) formula adjusted for having

8
the integral in Equation (3). This method introduces two types of approximation errors: (i)
the truncation errors arising from observing a …nite number, rather than an in…nite set of
strike prices, and (ii) a discretization error resulting from numerical integration. Jiang and
Tian (2005), however, show that both errors are small, if not negligible, in most empirical
settings.

Volatility Risk Premium. In this paper we study the predictive information content in
volatility swaps for future exchange rate returns. To this end, we work with the ex-ante payo¤
or ‘expected volatility premium’to a volatility swap contract. The volatility risk premium can
be thought of as the di¤erence between the physical and the risk-neutral expectations of the
future realized volatility.10 Formally, the -period volatility risk premium at time t is de…ned
as
V RPt; = EtP [RVt; ] EtQ [RVt; ] (5)

where EtP [ ] is the conditional expectation operator at time t under the physical measure
P. Following Bollerslev, Tauchen, and Zhou (2009), we proxy EtP [RVt; ] by simply using the
q P
P 252 2
lagged realized volatility, i.e., Et [RVt; ] = RVt ; = i=0 rt i , where rt is the daily

log return on the underlying security. This approach is widely used for forecasting exercises
– it makes V RPt; directly observable at time t, requires no modeling assumptions, and is
consistent with the stylized fact that realized volatility is a highly persistent process.11 Thus,
at time t, we measure the volatility risk premium over the [t; t + ] time interval as the ex-post
realized volatility over the [t ; t] interval and the ex-ante risk-neutral expectation of the
future realized volatility over the [t; t + ] interval, i.e., V RPt; = RVt ; EtQ [RVt; ].
For our purposes, we view currencies at each point in time t, with high V RPt; as those
which are relatively “cheap”to insure, as their expected realized volatility under the physical
measure, the variable against which agents hedge, is lower than the cost of purchasing option-
based insurance – which is primarily driven by expected volatility under the risk-neutral
measure. Conversely, those currencies with relatively low V RPt; are more “expensive” to

both domestic and foreign currency paying a continuous interest rate.


10
A number of papers de…ne the volatility risk premium as di¤erence between the risk-neutral and the
physical expectation. Here we follow Carr and Wu (2009) and take the opposite de…nition as it naturally
arises from the long-position in a volatility swap contract.
11
In our empirical work we also experiment with an AR(1) process for RV to form expectations of RV ,
and …nd that the results are virtually identical to those reported in the paper.

9
insure at time t. Our adoption of this terminology closely follows the logic in Garleanu,
Pedersen, and Poteshman (2009), who provide theory and empirical evidence to support the
conjecture that end-user demand for options has e¤ects on their prices when dealers cannot
perfectly hedge.

3 Data and Currency Portfolios


We now describe the data on spot and forward exchange rates, quotes on implied volatilities,
and the positions of market participants that we employ in our analysis. We also describe the
construction of currency portfolios using our measure of option expensiveness.

Exchange Rate Data. We collect daily spot and one-month forward exchange rates vis-
à-vis the US dollar (USD) from Barclays and Reuters via Datastream. The empirical analysis
uses monthly data obtained by sampling end-of-month rates from January 1996 to August
2011. Our sample consists of the following 20 countries: Australia, Brazil, Canada, Czech
Republic, Denmark, Euro Area, Hungary, Japan, Mexico, New Zealand, Norway, Poland,
Singapore, South Africa, South Korea, Sweden, Switzerland, Taiwan, Turkey, and United
Kingdom. We refer to this cross-section as “Developed and Emerging Countries.” A number
of currencies in this sample may not be traded in large amounts, even though quotes on forward
contracts (deliverable or non-deliverable) are available.12 Hence, we also consider a subset of
the most liquid currencies, which we refer to as “Developed Countries.” This sample includes:
Australia, Canada, Denmark, Euro Area, Japan, New Zealand, Norway, Sweden, Switzerland,
and the United Kingdom.

Currency Option Data. We employ daily data from January 1996 to August 2011 on
over-the-counter (OTC) currency options, obtained from JP Morgan.
The OTC currency option market is characterized by speci…c trading conventions. While
exchange traded options are quoted at …xed strike prices and have …xed calendar expiration
dates, currency options are quoted at …xed deltas and have constant maturities. More impor-
tantly, while the former are quoted in terms of option premia, the latter are quoted in terms
of Garman and Kohlhagen (1983) implied volatilities on baskets of plain vanilla options.
12
According to the Triennial Survey of the Bank for International Settlements (2010), the top 10 currencies
account for 90 percent of the average daily turnover in FX markets.

10
For a given maturity, quotes are typically available for …ve di¤erent combinations of plain-
vanilla options: at-the-money delta-neutral straddles, 10-delta and 25-delta risk-reversals,
and 10-delta and 25-delta butter‡y spreads. The delta-neutral straddle combines a call and a
put option with the same delta but opposite sign –this is the at-the-money (ATM) implied
volatility quoted in the FX market. In a risk reversal, the trader buys an out-of-the money
(OTM) call and sells an OTM put with symmetric deltas. The butter‡y spread is built up
by buying a strangle and selling a straddle, and is equivalent to the di¤erence between the
average implied volatility of an OTM call and an OTM put, and the implied volatility of a
straddle. From these data, one can recover the implied volatility smile ranging from a 10-delta
put to a 10-delta call.13 To convert deltas into strike prices, and implied volatilities into option
prices, we employ domestic and foreign interest rates, obtained from JP Morgan, which are
equivalent to those obtained using Datastream and Bloomberg.
This recovery exercise yields data on plain-vanilla European call and put options on 20
currency pairs vis-à-vis the US dollar, with maturity of one year. Practitioner accounts suggest
that natural hedgers such as corporates prefer hedging using intermediate-horizon derivative
contracts to the more transactions-costs intensive strategy of rolling over short term positions
in currency options, and hence the one-year volatility swap is a logical contract maturity
to detect interactions between hedgers and speculators. It is also the most liquid traded
maturity.14

Hedger Position Data. In our empirical analysis, we also use the net position of
commercial and non-commercial traders in exchange rate futures on the Chicago Mercantile
Exchange. These data are collected and reported monthly by the US Commodity Futures
Trading Commission (CFTC), and are often used to construct a measure of carry trade activity
(Curcuru, Vega, and Hoek, 2010). Implementation of a carry trade strategy is indicated by
a net long futures position in a target investment currency, say the Australian dollar, paired
with a net short futures position in a target funding currency, typically the Japanese yen.
Following Acharya, Lochstoer, and Ramadorai (2013), we construct the (normalized) net

13
In market jargon, a 25-delta call is a call whose delta is 0:25 whereas a 25-delta put is a put with a delta
equal to 0:25.
14
This is di¤erent from currency options per se, which tend to be most liquid at shorter maturities of one
and three months.

11
short futures position (i.e., short futures less long futures) of commercial and non-commercial
traders on the Australian dollar (AU D) and the Japanese yen (JP Y ) relative to the USD
dollar, respectively. The CFTC aggregates net positions in the FX futures market according
to commercial and non-commercial traders. This classi…cation, however, has signi…cant short-
comings as traders with a cash position in the underlying can be categorized as commercial
traders –this group may therefore include corporate …rms with an international line of busi-
ness, as well as banks with o¤setting positions in the underlying foreign currency (perhaps on
account of holding a position in the swap market). Since the de…ning line between commercial
and non-commercial traders is unclear, our measure is constructed as an aggregate measure
across both types of traders, which e¤ectively creates a measure of aggregate net short demand
from these groups, following any netting across the two. In our empirical work, we winsorize
this measure at the 1% and 99% percentile points.
A detailed description of the construction of this measure is reported in the Appendix.

Hedge Fund Flows. To construct a measure of new arbitrage capital available to


hedge funds, we use data from a large cross-section of hedge funds and funds-of-funds from
January 1996 to December 2011, which is consolidated from data in the HFR, CISDM, TASS,
Morningstar, and Barclay-Hedge databases, and comprises of roughly US$ 1.5 trillion worth
of assets under management (AUM) towards the end of the sample period. Patton and
Ramadorai (2013) provide a detailed description of the process followed to consolidate these
data.
We select the subset of 634 funds from these data, those self-reporting as currency funds
or global macro funds, and construct the net ‡ow of new assets to each fund as the di¤erence
between the fund’s assets under management (AUM) across successive months, adjusted for
the returns accrued by the fund over the month –this is tantamount to an assumption that
‡ows arrive at the end of the month, following return accrual. We then normalize the …gures
by dividing them by the lagged AUM, and then value-weight them across funds to create a
single aggregate time-series index of capital ‡ows to currency and global macro funds.

Order Flow Data. We employ a data set on customer order ‡ow in the FX market
in nine currency pairs over the sample period from January 2001 to May 2011. The nine
currencies cover our “Developed” sample with the exception of the Danish Krone, for which

12
order ‡ow data are not available. These data, used previously in Menkho¤, Sarno, Schmeling,
and Schrimpf (2013) and Della Corte, Rime, Sarno, and Tsiakas (2013), are obtained from a
top-tier FX dealing bank.
Customer order ‡ow in each of the nine currencies is measured as net buying pressure
against the US dollar (USD), that is, the US dollar volume of buyer-initiated minus seller-
initiated trades of a currency against the USD. The data cover all trades of customers of the
bank during our sample period. A positive (negative) number indicates net buying (selling)
pressure in the foreign currency relative to the USD.
In our empirical analysis, when aggregating or to allow for meaningful cross-currency
comparisons, we need to ensure that order ‡ows are comparable across currencies, as the
absolute size of order ‡ows di¤ers across currencies. We therefore standardize ‡ows by
dividing ‡ows by their standard deviation to remove the di¤erence in absolute order ‡ow sizes
across currencies:
xj;t
eR
x j;t = ; (6)
xj;t 3m

eR
where x j;t denotes order ‡ow standardized over a rolling window and xj;t denotes the raw order

‡ow. We compute the standard deviation of ‡ows over a rolling 63 trading-day (3 month)
window.
Our order ‡ow data can be distinguished into customer groups, namely, Asset Managers
(AM), Hedge Funds (HF), and Corporate Clients (CO). Asset Managers comprises entities
such as mutual funds and pension funds. Hedge Funds are unregulated entities in the set
of asset managers, and include highly leveraged traders not included in the asset manager
segment. Corporate Clients include non-…nancial corporations that import or export products
and services around the world, or those with an international supply chain. Corporate Clients
also include the treasury units of large non-…nancial corporations, with the exception of those
pursuing a highly leveraged investment strategy, in which case they are classi…ed as hedge
funds. In our analysis, we also aggregate ‡ows across all these segments, and refer to the
resulting currency-speci…c time-series as “Total Flows.”

Currency Excess Returns. We de…ne spot and forward exchange rates at time t as
St and Ft , respectively. Exchange rates are de…ned as units of US dollars per unit of foreign
currency such that an increase in St indicates an appreciation of the foreign currency. The

13
excess return on buying a foreign currency in the forward market at time t and then selling it
in the spot market at time t + 1 is computed as RXt+1 = (St+1 Ft ) =St which is equivalent
to the spot exchange rate return minus the forward premium RXt+1 = ((St+1 St ) =St )
((Ft St ) =St ). According to the CIP condition, the forward premium approximately equals
the interest rate di¤erential (Ft St ) =St ' it it , where it and it represent the domestic
and foreign riskless rates respectively, over the maturity of the forward contract. Since
CIP holds closely in the data at daily and lower frequency (e.g., Akram, Rime and Sarno,
2008), the currency excess return is approximately equal an exchange rate component (i.e., the
exchange rate change) minus an interest rate component (i.e., the interest rate di¤erential):
RXt+1 ' ((St+1 St ) =St ) (it it ), hence the moniker “excess return.”

Carry Trade Portfolios. At the end of each period t, we allocate currencies to …ve
portfolios on the basis of their interest rate di¤erential relative to the US (it it ) or forward
premia as (Ft St ) =St = (it it ) via CIP. This exercise implies that Portfolio 1 comprises
20% of all currencies with the highest interest rate di¤erential (lowest forward premia) and
Portfolio 5 comprises 20% of all currencies with the lowest interest rate di¤erential (highest
forward premia), and we refer to the long-short portfolio formed by going long Portfolio 1 and
short Portfolio 5 as CAR. We compute the excess return for each portfolio as an equally
weighted average of the currency excess returns within that portfolio, and individually track
both the interest rate di¤erential and the spot exchange rate component that make up these
excess returns.
Lustig, Roussanov, and Verdelhan (2011) study these currency portfolio returns using their
…rst two principal components. The …rst principal component implies an equally weighted
strategy across all long portfolios, i.e., borrowing in the US money market and investing in
foreign money markets. We refer to this zero-cost strategy as DOL. The second principal
component is equivalent to a long position in Portfolio 1 (investment currencies) and a short
position in Portfolio 5 (funding currencies), and corresponds to borrowing in the money mar-
kets of low yielding currencies and investing in the money markets of high yielding currencies.
We refer to this long/short strategy as CAR in our tables –and we use both DOL and CAR
in risk-adjustment below.

Momentum Portfolios. At the end of each period t, we form …ve portfolios based on

14
exchange rate returns over the previous 3-months. We assign the 20% of all currencies with
the highest lagged exchange rate returns to Portfolio 1, and the 20% of all currencies with
the lowest lagged exchange rate returns to Portfolio 5. We then compute the excess return
for each portfolio as an equally weighted average of the currency excess returns within that
portfolio. A strategy that is long in Portfolio 1 (winner currencies) and short in Portfolio 5
(loser currencies) is then denoted as M OM .15

Value Portfolios. At the end of each period t, we form …ve portfolios based on the
level of the real exchange rate. We assign the 20% of all currencies with the lowest real
exchange rate to Portfolio 1, and the 20% of all currencies with the highest real exchange
rate to Portfolio 5. We then compute the excess return for each portfolio as an equally
weighted average of the currency excess returns within that portfolio. A strategy that is long
in Portfolio 1 (undervalued currencies) and short in Portfolio 5 (overvalued currencies) is then
denoted as V AL.

Risk Reversal Portfolios. At the end of each period t, we form …ve portfolios based
on out of the money options. We compute for each currency in each time period the risk
reversal, which is the implied volatility of the 10 delta call less the implied volatility of the 10
delta put, and assign the 20% of all currencies with the lowest risk reversal to Portfolio 1, and
the 20% of all currencies with the highest risk reversal to Portfolio 5. We then compute the
excess return for each portfolio as an equally weighted average of the currency excess returns
within that portfolio. A strategy that is long in Portfolio 1 (high-skewness currencies) and
short in Portfolio 5 (low-skewness currencies) is then denoted as RR.

Volatility Risk Premia Portfolios. At the end of each period t, we group currencies
into …ve portfolios using the 1-year volatility risk premium constructed as described earlier.
We allocate 20% of all currencies with the highest expected volatility premia, i.e., those which
are cheapest to insure, to Portfolio 1, and 20% of all currencies with the lowest expected
volatility premia, i.e., those which are expensive to insure, to Portfolio 5. We then compute

15
Consistent with the results in Menkho¤, Sarno, Schmeling and Schrimpf (2012b), sorting on lagged
exchange rate returns or lagged currency excess returns to form momentum portfolios makes no qualitative
di¤erence to our results below. The same is true if we sort on returns with other formation periods in the
range from 1 to 12 months.

15
the average excess return within each portfolio, and …nally calculate the portfolio return from
a strategy that is long in Portfolio 1 (cheap volatility insurance) and short in Portfolio 5
(expensive volatility insurance), and denote it V RP .

4 The V RP Strategy: Empirical Evidence


Currency Portfolios Sorted on the Volatility Risk Premium. Table 1 presents sum-
mary statistics for the annualized average realized volatility RVt; , synthetic volatility swap
rate SWt; = EtQ [RVt; ], and volatility risk premium V RPt; = RVt; SWt; for the 1-year
maturity ( = 1) (in what follows, we drop the subscript, as it is always 1 year).
The table shows that, on average across currencies, RVt equals 10:68 percent, with a
standard deviation of 2:88 percent; SWt equals 11:31 percent, with a standard deviation of
2:75 percent; and therefore the average volatility risk premium V RPt across currencies is
the di¤erence between these two, and equal to 0:62 percent, with a standard deviation of
1:58 percent. For the full sample of developed and emerging countries, both RVt and SWt
are slightly larger than for the sample of only developed currencies, as is the volatility risk
premium, V RPt , which equals 0:92 on average. We might expect to see this –the average
price that natural hedgers have to pay to satisfy their demand for volatility insurance is larger
when including emerging market currencies.
Table 2 presents the basic result of our paper. In the table, we present the returns to
a number of long-short currency strategies computed using only time t 1 information, to
compare the predictability generated by strategies previously proposed in the literature with
the new V RP strategy that we propose. We compare CAR, M OM , V AL, and RR with our
V RP based strategy. We report results for both subsamples (Developed, and Developed and
Emerging) in our data.
Panel A of the table shows the results for the portfolio excess returns (including interest-
rate di¤erentials) generated by these trading strategies. Consistent with a vast empirical
literature (e.g., Lustig, Roussanov and Verdelhan, 2011; Burnside, Eichenbaum, Kleshchelski
and Rebelo, 2011; Menkho¤, Sarno, Schmeling and Schrimpf, 2012a), CAR delivers a very
high average excess return – indeed, the highest of all strategies considered. The Sharpe
ratio of the carry trade is 0.61 for the sample of developed countries, and 0.74 for the full

16
sample. M OM also generates positive excess returns, albeit less striking than carry, which is
consistent with the recent evidence in Menkho¤, Sarno, Schmeling and Schrimpf (2012b) that
the performance of currency momentum has weakened substantially during the last decade;
the Sharpe ratio is 0.27 for both samples of countries. Both V AL and RR do very well, with
Sharpe ratios of 0.62 and 0.48 respectively, with the strategy for V AL especially performing
well in the …nal few years of
In contrast, the V RP strategy that we introduce generates a Sharpe ratio of 0.48 and 0.29
for the two samples of countries considered, signifying that it outperforms the momentum
strategy. Perhaps surprisingly, the V RP strategy works better for the developed countries
in our sample than for the whole sample of developed and emerging countries. One plausible
explanation for this is that there is a greater prevalence of hedging using more sophisticated
instruments such as currency options in developed markets rather than in emerging mar-
kets. We note here that the Sharpe ratios for all of these strategies, including the V RP , are
statistically signi…cantly di¤erent from zero.16
Panel A of the table suggests that the returns to the V RP strategy are somewhat modest
in comparison with those of the other strategies that we provide as comparison. However
Panel B of the table introduces the main bene…t of the V RP strategy, namely that the
lion’s share of its returns accrue as a result of spot rate predictability. This predictability is
virtually twice as large as the best competitor strategy over the sample period, generating an
annualized mean spot exchange rate return of 4.4% for the developed countries, and 3.72%
for the full cross-section of all 20 countries in our sample. In contrast, the exchange rate
return from CAR is close to zero for both samples, and while other strategies, notably V AL,
have relatively better performance in predicting movements in the spot rate than CAR, the
preponderance of their returns are derived from interest rate di¤erentials. Moreover, the
Sharpe ratio for the exchange rate component of CAR is insigni…cantly di¤erent from zero,
whereas the Sharpe ratio for V RP is statistically signi…cant in all cases considered.
Several of the other moments in Panel B of Table 2 are also worth highlighting. First,

16
We estimate the standard error of the Sharpe ratio using the formula for non-iid returns via delta-
method and using a generalized method of moment
p (GMM) estimator (Lo, 2002). Speci…cally, the asymptotic
c a
distribution of the Sharpe ratio is de…ned as T (SR SR) N (0; V ), where V = @g
@
@g
@ 0, = ( ; )0 ,
@g 0
@ = 1= ; = 2 , and is the variance-covariance matrix of . We estimate via GMM and using
Newey and West (1987) with the optimal lag length according to Andrews (1991).

17
the returns from V RP display desirable skewness properties, as its unconditional skewness
is positive (albeit small for the full sample), and the maximum drawdown is comparable to
that of M OM and far better (i.e., higher) than that of CAR. Another way to see this, of
course, is to compare the (very di¤erent) returns to RR and V RP , as RR is constructed to
replicate a long high skewness-short low skewness portfolio. Finally, the table shows that the
portfolio turnover of the VRP strategy (measured in terms of changes in the composition of
the short and long legs of the VRP strategy) is reasonable – lying in between the very low
turnover of CAR and the high turnover of M OM . The weights in the V RP strategy are
fairly stable over time, meaning that the VRP strategy is likely to perform well also for lower
rebalancing periods and that transaction costs – which are known to be relatively small in
currency markets –are unlikely to impact signi…cantly on the performance of V RP .
Finally, Panel C of Table 2 documents the correlation of the V RP strategy with the other
strategies, and …nds that the strategy tends to be negatively correlated with CAR (with
correlations of -0.18 and -0.21 for the two samples) and only mildly positively correlated with
M OM (with correlations of 0.09 and 0.10 for the two samples). The correlation with V AL
for Developed countries is higher, but at 0.23, there is substantial orthogonal information in
the strategy – indeed several of the other strategies are much more highly correlated with
one another. Apart from showing that the strategy is distinct from those already studied
in the literature, this also implies that combining V RP with CAR, M OM , V AL, and RR
may well yield sizable diversi…cation bene…ts to an investor. It is also useful to note that the
correlations for the excess returns from the strategies, presented in the table, are very close in
magnitude to the correlations acquired from the exchange rate component of these returns.
Figure 1 provides a graphical illustration of the di¤erences in the performance of the
strategies highlighted in Table 2, and restricts the plot to the sample of Developed Countries
to conserve space. The …gure plots the one-year rolling Sharpe ratio for these strategies, and
make visually clear the marked di¤erence in the evolution of risk-adjusted returns of V RP
relative to the others. While there is a substantial improvement in the Sharpe ratio of V RP
during the recent crisis, the strategy is not driven entirely by this or other particular episodes
or sample period as the Sharpe ratio has been relatively stable over the sample, and appears
to be no more volatile than the Sharpe ratio of CAR and M OM .
Table 3 shows the subsample performance of the currency component of these strategies

18
as a complement to Figure 1. It is clear that the performance of V RP is greater in crisis
and NBER recession periods. However it is important to highlight that especially for the full
sample of Developed and Emerging countries, it is still large and positive, and higher than
all the competitor strategies. Even if V RP were to be used primarily as a hedge, it has very
desirable properties, delivering positive returns outside of crisis periods, and very high returns
within crisis periods.
Figure 2 plots the cumulative returns over of the strategies over the sample period (again,
only for the Developed Countries), with a particular focus on decomposing the cumulative
excess return into its two constituents: the exchange rate component (FX) and the interest rate
gain component (yield). Both CAR and M OM have a positive yield component, although
in the case of the carry trade the yield component is the sole positive driver of the carry
return because the cumulative FX return component is negative. For M OM , most of the
excess return is driven by spot predictability so the cumulative yield component has a positive
but relatively minor contribution to momentum returns. V RP returns are di¤erent in that
they are made up of a negative yield component (for both sample of countries considered),
and therefore the component due to spot return predictability is in fact larger than the full
portfolio return. The performance of V RP is similar to V AL, except that V AL also has
positive yield, but far lower currency returns.
Table 4 provides further details and statistics to understand the properties of the returns
generated by our short expensive-to-insure, long cheap-to-insure currency strategy, reporting
summary statistics for the …ve portfolios that are obtained when sorting on the volatility risk
premium. In this table, PL is the long portfolio that buys the top 20% of all currencies with
the cheapest volatility insurance, P2 buys the next 20% of all currencies ranked by expected
volatility premia, and so on till the …fth portfolio, PS which is the portfolio that buys the top
20% of all currencies which are the most expensive to insure. V RP essentially buys PL and
sells PS , with equal weights, so that V RP = PL PS .
The table reveals several facts that re…ne our understanding of V RP . First, there is a
strong general tendency of portfolio returns to decrease as we move from PL towards PS ; the
decrease is not monotonic for developed countries, but it is monotonic for the full sample,
for the currency returns component. Second, in normal times, the V RP return stems from
the long portfolio, PL , although as the top panel of Figure 3 later reveals, PS delivers a high

19
kick during the recent and other crisis periods. Third, the return from PL can be virtually
completely attributed to spot rate changes. Finally, the bottom panel of Table 4 shows the
transition matrix between portfolios. This shows that, while there is a fairly persistent
tendency for currency insurance costs to remain stable, there is nonetheless currency rotation
across quintile portfolios such that the steady-state transition probabilities are identical. Thus
the performance of the strategy cannot simply be attributed to long-lived long and short
positions in particular currencies.
Taken together, the results from this section suggest that, while the carry trade strategy is
–taken in isolation –the best performing strategy in terms of excess returns and delivers the
highest Sharpe ratio, the V RP strategy has much stronger predictive power than for exchange
rate returns, which is largely independent from that derived from alternative currency trading
strategies. This means that a currency manager would bene…t greatly from adding V RP to
a currency portfolio to enhance risk-adjusted returns, and also that a spot trader interested
in forecasting exchange rate ‡uctuations (as opposed to excess returns) would value V RP
greatly.17

5 Pricing V RP Returns
In this section we carry out both cross-sectional and time-series asset pricing tests to determine
whether V RP returns can be understood as compensation for systematic risk.

5.1 Time-Series Regressions

As a …rst step, Table 5 simply regresses the time-series of V RP on a number of factors


proposed in the literature. First, Panel A con…rms the results found in Tables 2 and 3, by
using DOL, CAR, M OM , V AL, and RR as right-hand side variables, and shows that for both
Developed and Developed and Emerging samples, there is substantial alpha relative to these
factors. Panel B uses the three Fama-French factors and adds equity market momentum,
denoted M OM E. Again, V RP has alpha relative to these factors which is virtually identical
to that in the prior Panel. Finally, Panel C of Table 5 employs the Fung-Hsieh (2004) factor

17
We also compute volatility risk premia using the simple variance swap formula of Martin (2012). Results
are virtually identical for developed countries and improve for developed and emerging countries. We report
these results in the Internet Appendix.

20
model, which has been used in numerous previous studies; see for example, Bollen and Whaley
(2009), Ramadorai (2013), and Patton and Ramadorai (2013). The set of factors comprises
the excess return on the S&P 500 index; a small minus big factor constructed as the di¤erence
between the Wilshire small and large capitalization stock indexes; excess returns on portfolios
of lookback straddle options on currencies, commodities, and bonds, which are constructed
to replicate the maximum possible return to trend-following strategies on their respective
underlying assets; the yield spread of the US 10-year Treasury bond over the 3-month T-bill,
adjusted for the duration of the 10-year bond; and the change in the credit spread of Moody’s
BAA bond over the 10-year Treasury bond, also appropriately adjusted for duration. Yet
again, the table shows that the alpha of V RP is virtually una¤ected by the inclusion of these
factors.

5.2 Cross-Sectional Tests

Our cross-sectional tests rely on a standard stochastic discount factor (SDF) approach (Cochrane,
2005), and we focus on a set of risk factors in our investigation that are motivated by the ex-
isting currency asset pricing literature. We begin by brie‡y reviewing the methods employed,
i
and denote excess returns of portfolio i in period t + 1 by RXt+1 . The usual no-arbitrage
relation applies, so risk-adjusted currency excess returns have a zero price and satisfy the
basic Euler equation:

i
E[Mt+1 RXt+1 ] = 0; (7)

with a linear SDF Mt = 1 b0 (ft ), where ft denotes a vector of risk factors, b is the vector
of SDF parameters, and denotes factor means.
This speci…cation implies a beta pricing model in which expected excess returns depend
on factor risk prices , and risk quantities i, which are the regression betas of portfolio excess
returns on the risk factors:
0
E RX i = i (8)

for each portfolio i (see e.g., Cochrane, 2005).


The relationship between the factor risk prices in equation (8) and the SDF parameters in
equation (7) is simply given by = f b, where f is the covariance matrix of the risk factors.

21
Thus, factor risk prices can be easily obtained via the SDF approach, which we implement
by estimating the parameters of equation (7) via generalized method of moments (GMM).18
We also present results from the more traditional Fama-MacBeth (FMB) approach in our
empirical implementation.
In our asset pricing tests we consider a two-factor linear model that comprises DOL and one
additional risk factor, which is one of CAR and V OLF X . DOL denotes the average return
from borrowing in the US money market and equally investing in foreign money markets.
CAR is the carry portfolio described earlier. V OLF X is a global FX volatility risk factor
constructed as the innovations to global FX volatility, i.e., the residuals from an autoregressive
model applied to the average realized volatility of all currencies in our sample, as in Menkho¤,
Sarno, Schmeling, and Schrimpf (2012a).19
In assessing our results, we are aware of the statistical problems plaguing standard asset
pricing tests, recently emphasized by Lewellen, Nagel, and Shanken (2010). Asset-pricing
tests can often be highly misleading, in the sense that they can indicate strong but illusory
explanatory power through high cross-sectional R2 statistics, and small pricing errors, when
in fact a risk factor has weak or even non-existent pricing power. Given the relatively small
cross-section of currencies in our data, as well as the relatively short time span of our sample,
these problems can be severe in our tests. As a result, when interpreting our results, we only
consider the cross-sectional R2 and HJ tests on the pricing errors, if we can con…dently detect
a statistically signi…cant risk factor, i.e., if the GMM estimates clearly point to a statistically
signi…cant market price of risk on a factor.
Table 6 reports GMM estimates of b, portfolio-speci…c ’s, and implied ’s, as well as
cross-sectional R2 statistics and the Hansen-Jagannathan (HJ) distance measure (Hansen and
Jagannathan, 1997). In the table, standard errors are constructed as in Newey and West (1987)

18
Estimation is based on a pre-speci…ed weighting matrix and we focus on unconditional moments (i.e. we
do not use instruments other than a constant vector of ones) since our interest lies in the performance of the
model to explain the cross-section of expected currency excess returns (see Cochrane, 2005; Burnside, 2011).
19
In the Internet Appendix, we also consider the innovations to global average precentage bid-ask spreads
in the spot market (BASF X ) and the option market (BASIV ). BASF X is constructed by averaging over
a month the daily average bid-ask spread of the spot exchange rates. BASIV is constructed by averaging
over a month the daily average bid-ask spread of the 1-year at-the-money implied volatilities. Innovations
are computed as the residuals to a …rst-order autoregressive process. Higher bid-ask spreads indicate lower
liquidity, so that our aggregate measures can be seen as global proxy for the FX spot market and the FX
option market illiquidity, respectively.

22
with optimal lag length selection according to Andrews (1991). Besides the GMM tests, we
employ traditional FMB two-pass OLS regressions to estimate portfolio betas and factor risk
prices. Note that we do not include a constant in the second stage of the FMB regressions, i.e.
we do not allow a common over- or under-pricing in the cross-section of returns - however our
results are virtually identical when we replace the DOL factor with a constant in the second
stage regressions.20 Since DOL has virtually no cross-sectional relation to portfolio returns,
it serves the same purpose as a constant that allows for a common mispricing.
Panels A and B of Table 6 show clearly how neither of the risk factors considered enters the
SDF with a statistically signi…cant risk price , and that this is the case for both the developed
countries and the full sample. As expected, the FMB results in the table are qualitatively, and
in most cases also quantitatively identical to the one-step GMM results. The bottom part of
the panels show that there is little cross-sectional variation across the 5 portfolios sorted by
the cost of currency insurance, which is what we con…rm more formally in the asset pricing
tests.
The best performing SDF in these tests includes DOL and V OLF X , and generates a
respectable cross-sectional R2 (0.27), but the market price of risk is insigni…cantly di¤erent
from zero. The HJ test delivers large p-values for the null of zero pricing errors in all cases
but we attach no information to this result given the lack of clear statistical signi…cance of the
market price of risk. We also carried out asset pricing tests using the same methods and risk
factors in which we attempt to price only the exchange rate component of the returns from
V RP . The results are equally disappointing in that all risk factors included in the various
SDF speci…cations are statistically insigni…cant.
Overall, the asset pricing tests reveal that it is not possible to understand the returns from
the V RP strategy as compensation for risk, using the carry risk factor, global volatility risk,
or illiquidity in the FX market of the kind used in the literature. These results are consistent
with our earlier results that indicate that V RP returns are very di¤erent from carry and
momentum returns, and hence their source is likely to stem from a di¤erent mechanism than
compensation for canonical sources of systematic risk. Therefore, we now turn to examining
potential explanations.

20
Also see Lustig and Verdelhan (2007) and Burnside (2011) on the issue of whether or not to include a
constant in these regressions.

23
6 Understanding the Drivers of V RP
We consider two possible alternative explanations for our results. The …rst is Aversion
to Volatility Risk. It might be the case that the currency-speci…c volatility risk premium
captures ‡uctuations in aversion to volatility risk. As a result, currencies with relatively
expensive volatility insurance would have low expected returns and vice versa.
Our V RP strategy is cross-sectional, since we are long and short currencies simultaneously.
As a result, if this explanation were correct, it would rely either on di¤erent currencies loading
di¤erently on a global volatility shock, or indeed on market segmentation causing expected
returns on di¤erent currencies to be determined independently. This latter possibility is very
di¢ cult to evaluate, and if our strategy did indeed provide evidence of this, it would have
far-reaching consequences.
To evaluate the …rst of these possibilities, i.e., currencies loading di¤erently on a global
volatility shock, we have already tested the impacts of the global FX volatility risk factor of
Menkho¤, Sarno, Schmeling, and Schrimpf (2012a) and found it to be ine¤ective at pricing
the returns from our portfolio. However it could be the case that this proxy is not the best
suited to capture the returns from our strategy, and we try other possibilities. We do so by
estimating the loadings of currency returns on various proxies for global volatility risk, and
building portfolios sorted on these estimated loadings. Speci…cally, we estimate the following
regression:
RXit = i + i GV OLt + "it ;

for each currency i: Here GV OL is a proxy for global volatility risk premia and we employ
various measures, including the average volatility risk premium across our currencies (with
equal weights); the …rst principal component of the currencies’ volatility risk premia; and
the equity volatility risk premium computed as the di¤erence between the time-t one-month
realized volatility on the S&P500, and the VIX index.
We estimate these regressions using rolling windows of 36 months. After obtaining esti-
mates of the i coe¢ cients, we sort currencies into …ve portfolios on the basis of these i

estimates. Finally, we construct a long-short strategy which buys currencies with low betas
and sells currencies with high betas. In essence, this strategy exploits di¤erences in exposure
of individual currencies to global measures of volatility risk premia, which is a direct test of

24
the above hypothesis.
The results using our three measures for GV OL are qualitatively identical and we report
in Table 7 the results for GV OL set equal to the average volatility risk-premium across the
currencies in our sample. The Internet Appendix contains results for the other two measures.
The table shows that the performance of this strategy is strictly inferior to the performance
of the V RP strategy, and the correlation between the returns from the two strategies is very
low. Figure 3 provides a clear picture of these results in time-series, showing the dramatic
di¤erence between the returns from V RP displayed in the top part of the …gure, and those
from the construction based on correlations of currency returns with global volatility, in the
bottom panel. On the basis of this evidence, we conclude that there is little support for
V RP returns being driven by aversion to global volatility risk in the data.
The second possible explanation that we consider is Limits to Arbitrage, in the spirit
of Acharya, Lochstoer, and Ramadorai (2013). According to this explanation, the returns
to V RP arise from the interaction between natural hedgers of FX risk, and currency market
speculators. When currency-market arbitrage is limited, and particular currencies are rela-
tively expensive or cheap to insure, this results in inventory pressure on expensive-to-insure
currencies as they are sold by natural hedgers, and relatively less pressure on cheap-to-insure
currencies, for which natural hedgers are happy to hold higher inventories. This yields the
positive long-short returns in the V RP portfolio.
This explanation has implications which we test in Table 8. The table presents coe¢ cients
from predictive time-series regressions of the exchange rate component of V RP on a number
of conditioning factors implied by this mechanism. We report results from the exchange rate
component of V RP since we are primarily interested in understanding the predictive power
for spot exchange rates, but the results for excess returns are, not surprisingly, qualitatively
identical and quantitatively very similar.21
The …rst column in both panels shows the univariate regression of the exchange rate
component of V RP on the 12-month rolling average of the lagged TED spread. When
funding liquidity is lower (i.e., times of high capital constraints on speculators), we should
…nd that the expected (exchange rate) return from V RP should increase, and Table 8 provides
strong con…rmation for this for developed countries. While the sign of the coe¢ cient on TED
21
See the Internet Appendix for a detailed description of the conditioning factors used for this exercise.

25
is positive for the full sample of countries, it is not statistically signi…cant. This could be
because the TED spread is possibly less useful as a proxy for funding liquidity constraints in
emerging markets.
The second column shows that when the 12-month rolling average of changes in VIX (our
proxy for increases in the risk aversion of market participants, yielding both greater limits to
arbitrage and an increased desire to hedge) is positive, V RP returns increase, again consistent
with the limits to arbitrage explanation. Yet again, this result is only signi…cant for the sample
of developed countries. Similarly, the third column shows that a general …nancial distress
indicator (FSI, constructed by the Federal Reserve Bank of St. Louis) that captures the
principal component of a variety of liquidity and volatility indicators is statistically signi…cant.
The fourth column of the table interacts TED with changes in VIX, and …nds strong
statistically signi…cant predictive power of this interaction for the FX returns on our strategy in
both developed and emerging countries, suggesting that when funding liquidity is constrained
and risk aversion is high, that V RP returns increase.
The next three columns check the predictive ability for V RP of market participants’
positioning information. The …rst two of these columns use the (normalized) net short
futures position of commercial and non-commercial traders on the Australian dollar (AU D)
and the Japanese yen (JP Y ) relative to the USD dollar, respectively. For Developed as well
as Developed and Emerging samples, at times when there is greater futures-related hedging
of the AU D by commercial and non-commercial traders, the returns to the V RP strategy
increase. However, we …nd no real impact for the net short position on the JP Y . The …nal
column of the table adds in measures of capital ‡ows into hedge funds. When aggregate
capital ‡ows into hedge funds are high, signifying that they experience fewer constraints on
their ability to engage in arbitrage transactions, we …nd that returns for our V RP strategy
are lower and vice versa.
The …nal three rows of Table 8 consider several of the variables described above simul-
taneously to test their joint and separate explanatory power. We include TED, changes in
VIX and the interaction separately to avoid potential collinearity in the regressions as these
variables are highly correlated with one another. More generally, it is clear that the vari-
ables used in the univariate regressions are likely to contain a substantial common component.
Nonetheless, we …nd that all these variables retain their signs and are generally statistically

26
signi…cant in these multivariate predictive regressions, o¤ering support to the limits to arbi-
trage explanation of our results.
Next, we examine post-formation portfolio returns. If the limits to arbitrage explanation
is correct, the predictability of volatility insurance costs cannot be long-lived. According
to this explanation, either speculators face a shock that reduces their available arbitrage
capital and limits their ability to provide cheap volatility insurance, or there is an increase
in hedger risk aversion causing their demand for hedging to risk. As a result, net demand
for volatility insurance increases, making hedging more expensive, which will be re‡ected in
a lower volatility risk premium, i.e., more expensive currency options. In the face of high
volatility insurance costs, natural hedgers scale back on the amount of spot currency they
are willing to hold, predictably depressing spot prices and leading to relatively low returns
on the spot currency position. When capital constraints loosen, however, we should see
the opposite behavior, i.e., the volatility risk premium reverts to the mean, and reversals in
currency returns.
This yields an additional testable implication, namely, reversal in post-formation cumula-
tive returns on the V RP strategy, which is exactly what we …nd in Figure 4. The …gure plots
cumulative post-formation risk-adjusted excess returns (left panel) and risk-adjusted currency
returns (right panel) over periods of 1; 2; : : : ; 20 months for the VRP-sorted portfolios, for
both samples of countries examined.22 Returns in the post-formation period are overlapping,
as we form new portfolios each month, but track these portfolios for 20 months.
In the …gure, the excess returns increase and peak after 3 months for the Developed
Countries sample and 4 months for the full sample, and subsequently decline. Looking at spot
exchange rate returns, the peak in cumulative post-formation exchange rate return occurs
around 4 months for the developed sample and 5-6 months for the full sample. This evidence
of a reversal appears consistent with the prediction of the limits to arbitrage explanation of
the economic source of VRP predictive power. Moreover the relatively high frequency of
the reversal suggests that an explanation based on risk aversion to volatility combined with

22
Speci…cally, we plot returns net of the exposure to carry trade risk, i.e., we use the residuals from a
regression of V RP returns on CAR, so that the returns can be considered as alphas over and above carry
trade returns. Using raw portfolio returns or their exchange rate component produces a very similar pattern
for the full sample, and a virtually identical pattern for the developed sample, as expected given that we know
already from previous analyses that CAR has little pricing power for V RP portfolios.

27
market segmentation, an explanation described earlier, is somewhat less likely.
Finally, we examine whether the observed buying and selling actions of di¤erent players
in the spot currency market follow the pattern implied by the limits to arbitrage explanation,
i.e., that currencies in the high volatility-insurance portfolio are sold and those in the low
volatility insurance portfolio are bought. We do so using actual order ‡ow data, essentially
taking the currencies ranked by their volatility insurance costs, and documenting their order
‡ow, rather than their returns.
Table 9 presents the results of this exercise, disaggregated by end-customer type. We …nd
that the order ‡ow of corporate clients follows exactly the pattern implied by the limits to
arbitrage explanation –such end-users of currencies sell expensive-insurance (PS ) currencies
and buy cheaper-insurance (PL ) currencies. Asset managers demonstrate exactly the oppo-
site behavior, acting as market-makers that provide liquidity to satisfy the buying (selling)
demand for low (high)-insurance currencies. Hedge funds appear to either be susceptible to
currency volatility insurance pressures, or to engage in destabilizing rational speculation, as
their behavior appears similar to that of the corporate clients. Finally, total net order ‡ow,
which is the sum of the order ‡ows of the three collectively exhaustive categories of market
participants for which order ‡ow data is available, is positive (negative) for cheaper (expen-
sive) insurance currencies. This is consistent with the net demand of these market participants
relative to FX dealers being non-zero, thus generating price pressure in the spot market on
average, consistent with high returns to the V RP strategy.
Figure 5 plots the daily cumulated order ‡ow in the extreme V RP portfolios for each group
of market participants. These graphs show that the averages of order ‡ow that we document
in Table 9 display interesting time-variation, consistent with greater impacts during the crisis,
though not exclusively limited to any single time-period.
Taken together, the results in this section lend support to a limits to arbitrage explanation
for the predictability of spot exchange rates associated with V RP . There is a growing
theoretical and empirical literature that highlights the role of limits to arbitrage and the
interaction between hedgers and speculators in asset markets, and we view our results as
adding currency markets to the list of venues in which such mechanisms are at work.

28
7 Conclusions
We show that the currency volatility risk premium has substantial predictive power for the
cross-section of currency returns. Sorting currencies by their volatility risk premia gener-
ates economically signi…cant returns in a standard multi-currency portfolio setting. This
predictive power is speci…cally related to spot exchange rate returns, and not to interest
rate di¤erentials, and the spot rate predictability is much stronger than that observed from
carry, currency momentum, currency value, or risk-reversal strategies. Moreover, the returns
from the volatility risk premium strategy are largely uncorrelated with these other currency
strategies, thus providing a potentially important diversi…cation gain to investors.
We …nd that currencies for which volatility insurance is relatively cheap predictably appre-
ciate, while currencies for which volatility hedging using options is relatively more expensive
predictably depreciate. Standard risk factors cannot price the returns from the long-short
portfolio that we construct from these components. We consider two candidate explanations
for these …ndings, and provide evidence that they can be rationalized in terms of the time-
variation of limits to arbitrage capital and the incentives of hedgers and speculators in currency
markets.
Overall, the results in our paper provide new insights into the predictability of exchange
rate returns, an area in which evidence has been di¢ cult to obtain. We also see our work as
adding currency markets to the growing list of markets in which understanding the interactions
between hedgers and speculators is critically important.

29
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34
Table 1. Volatility Risk Premia

This table presents summary statistics for the average 1-year realized volatility RVt (Panel A), synthetic
volatility swap rate SWt (Panel B ), and volatility risk premium V RPt = RVt SWt (Panel C ) in foreign
exchange. RVt is computed at time t using daily exchange rate returns over the previous year. SWt is
constructed at time t using the 1-year implied volatilities across 5 di¤erent deltas from the foreign exchange
option market. The volatility risk premium V RPt is constructed as the di¤erence between RVt and SWt . Qj
refers to the j th percentile. AC indicates the 1-year autocorrelation coe¢ cient. RVt , SWt , and V P Rt are
expressed in percentage per annum. The sample period comprises daily data from January 1996 to August
2011. Exchange rates are from Datastream whereas implied volatility quotes are proprietary data from JP
Morgan.

RVt SWt V RPt RVt SWt V RPt


Developed Developed & Emerging
M ean 10:68 11:31 0:62 10:82 11:74 0:92
Sdev 2:88 2:75 1:58 3:10 3:22 1:78
Skew 1:85 1:42 0:54 2:12 2:07 0:31
Kurt 6:86 5:29 5:97 7:85 8:06 7:88
Q5 7:15 7:77 3:06 7:23 8:36 3:67
Q95 18:40 16:76 1:65 19:43 17:86 1:57
AC 0:33 0:53 0:19 0:27 0:46 0:17

35
Table 2. Currency Strategies

This table presents descriptive statistics of currency strategies formed using time t 1 information. CAR
is the carry trade strategy that buys (sells) the top 20% of all currencies with the highest (lowest) interest
rate di¤erential relative to the US dollar. Similarly, M OM is the momentum strategy that buys (sells)
currencies with the highest (lowest) past 3-month exchange rate return, V AL is the value strategy that buys
(sells) currencies with lowest (highest) real exchange rate, RR is the risk reversal strategy that buys (sells)
currencies with the lowest (highest) 1-year risk reversal, and V RP is the volatility risk premium strategy
that buys (sells) currencies with the highest (lowest) 1-year volatility risk premium. The table also reports
the …rst order autocorrelation coe¢ cient (AC1 ), the annualized Sharpe ratio (SR), the Sortino ratio (SO),
the maximum drawdown (M DD), and the frequency of portfolio switches for the long (F reqL ) and the short
(F reqS ) position. The superscript denotes positive and statistical signi…cant SRs at 5% level computed
via delta-method using the generalized method of moments (Lo, 2002). Panel A displays the overall currency
excess return whereas Panel B reports the exchange rate return component only. Panel C presents the sample
correlations of the currency excess returns. Returns are expressed in percentage per annum. The strategies
are rebalanced monthly from January 1996 to August 2011. Exchange rates are from Datastream whereas
implied volatility quotes are proprietary data from JP Morgan.

Panel A: Excess Returns


CAR M OM V AL RR V RP CAR M OM V AL RR V RP
Developed Developed & Emerging
M ean 6:49 2:58 5:78 5:30 4:03 7:42 2:22 3:55 5:38 2:34
Sdev 10:66 9:55 9:38 11:40 8:33 9:97 8:30 8:90 10:60 8:18
Skew 0:92 0:35 0:26 0:72 0:28 0:92 0:03 0:15 0:14 0:12
Kurt 5:65 3:86 3:50 6:58 3:47 4:53 2:95 3:17 4:43 3:26
SR 0:61 0:27 0:62 0:46 0:48 0:74 0:27 0:40 0:51 0:29
SO 0:72 0:50 0:94 0:58 0:87 0:94 0:47 0:62 0:75 0:49
M DD 0:37 0:16 0:14 0:37 0:18 0:21 0:13 0:14 0:24 0:18
AC1 0:09 0:00 0:03 0:07 0:04 0:01 0:09 0:01 0:08 0:05
F reqL 0:13 0:48 0:09 0:17 0:24 0:15 0:49 0:07 0:22 0:26
F reqS 0:07 0:43 0:07 0:27 0:32 0:16 0:46 0:06 0:26 0:27
Panel B: FX Returns
M ean 0:34 2:03 2:95 1:42 4:40 0:65 1:45 0:06 0:22 3:72
Sdev 10:66 9:57 9:44 11:48 8:35 9:99 8:16 8:89 10:60 8:17
Skew 0:93 0:42 0:29 0:75 0:28 1:05 0:02 0:16 0:21 0:12
Kurt 5:82 4:17 3:51 6:83 3:61 4:84 3:13 3:19 4:74 3:50
SR 0:03 0:21 0:31 0:12 0:53 0:07 0:18 0:01 0:02 0:46
SO 0:04 0:40 0:47 0:15 0:93 0:08 0:30 0:01 0:03 0:75
M DD 0:43 0:20 0:24 0:40 0:19 0:35 0:15 0:27 0:29 0:18
AC1 0:11 0:00 0:02 0:08 0:04 0:03 0:12 0:01 0:08 0:04
F reqL 0:13 0:48 0:09 0:17 0:24 0:15 0:49 0:07 0:22 0:26
F reqS 0:07 0:43 0:07 0:27 0:32 0:16 0:46 0:06 0:26 0:27
Panel C: Correlations
CAR 1:00 0:17 0:44 0:68 0:18 1:00 0:03 0:54 0:57 0:21
M OM 0:17 1:00 0:17 0:17 0:09 0:03 1:00 0:14 0:15 0:10
V AL 0:44 0:17 1:00 0:49 0:23 0:54 0:14 1:00 0:64 0:10
RR 0:68 0:17 0:49 1:00 0:01 0:57 0:15 0:64 1:00 0:12
V RP 0:18 0:09 0:23 0:01 1:00 0:21 0:10 0:10 0:12 1:00

36
Table 3. Currency Strategies: Sub-Samples

This table presents descriptive statistics of foreign exchange (FX) returns to currency strategies formed
using time t 1 information. CAR is the carry trade strategy that buys (sells) the top 20% of all currencies
with the highest (lowest) interest rate di¤erential relative to the US dollar. Similarly, M OM is the momentum
strategy that buys (sells) currencies with the highest (lowest) past 3-month exchange rate return, V AL is the
value strategy that buys (sells) currencies with lowest (highest) real exchange rate, RR is the risk reversal
strategy that buys (sells) currencies with the lowest (highest) 1-year risk reversal, and V RP is the volatility
risk premium strategy that buys (sells) currencies with the highest (lowest) 1-year volatility risk premium.
The superscript denotes positive and statistical signi…cant SRs at 5% level computed via delta-method
using the generalized method of moments (Lo, 2002). Returns are expressed in percentage per annum. The
strategies are rebalanced monthly from March 2001 to November 2001, and from December 2007 to June 2009
(Panel A), from January 1996 to December 2006 (Panel B ), and from January 2007 to August 2011 (Panel
C ). January 1996 to August 2011. Exchange rates are from Datastream whereas implied volatility quotes are
proprietary data from JP Morgan.

Panel A: NBER Recession Periods


CAR M OM V AL RR V RP CAR M OM V AL RR V RP
Developed Developed & Emerging
M ean 9:59 11:32 4:62 7:96 11:54 7:97 7:07 0:10 4:80 6:50
Sdev 17:11 15:40 12:03 19:07 10:11 14:69 10:49 9:92 15:20 9:38
Skew 0:44 0:28 0:63 0:90 0:12 0:80 0:17 0:15 0:08 0:45
Kurt 3:71 2:87 3:43 4:13 2:26 2:84 2:77 2:95 2:54 2:88
SR 0:56 0:74 0:38 0:42 1:14 0:54 0:67 0:01 0:32 0:69
M DD 0:40 0:16 0:12 0:41 0:09 0:32 0:07 0:18 0:29 0:09
AC1 0:35 0:12 0:09 0:23 0:27 0:17 0:04 0:09 0:31 0:22
Panel B: non-NBER Recession Periods
M ean 2:09 0:40 2:65 3:08 3:14 0:64 0:46 0:05 1:11 3:23
Sdev 9:06 8:11 8:95 9:57 7:99 8:92 7:68 8:73 9:61 7:96
Skew 0:87 0:04 0:16 0:11 0:26 0:92 0:19 0:16 0:17 0:26
Kurt 4:50 2:48 3:30 4:16 4:02 4:90 2:90 3:22 5:55 3:70
SR 0:23 0:05 0:30 0:32 0:39 0:07 0:06 0:01 0:12 0:41
M DD 0:31 0:21 0:22 0:15 0:16 0:31 0:20 0:22 0:20 0:16
AC1 0:07 0:09 0:02 0:04 0:03 0:06 0:15 0:00 0:02 0:02
Panel C: Pre-Crisis Period
M ean 1:91 0:81 3:00 2:94 2:18 1:09 0:71 0:58 1:28 3:04
Sdev 8:33 7:90 9:78 9:43 7:99 9:16 7:68 9:25 10:12 8:53
Skew 0:91 0:02 0:31 0:32 0:07 1:06 0:01 0:25 0:24 0:19
Kurt 4:92 2:46 3:26 4:14 3:46 5:20 2:59 3:10 5:41 3:47
SR 0:23 0:10 0:31 0:31 0:27 0:12 0:09 0:06 0:13 0:36
M DD 0:31 0:16 0:24 0:15 0:19 0:31 0:14 0:23 0:18 0:18
AC1 0:05 0:11 0:03 0:02 0:01 0:08 0:14 0:02 0:03 0:02
Panel B: Crisis Period
M ean 3:34 4:88 2:81 2:13 9:61 4:73 3:17 1:15 2:25 5:30
Sdev 14:80 12:69 8:67 15:31 9:05 11:70 9:23 8:05 11:72 7:29
Skew 0:66 0:50 0:22 1:13 0:54 0:89 0:10 0:12 0:12 0:07
Kurt 4:02 3:57 4:27 5:63 3:42 3:90 3:56 3:41 3:67 3:39
SR 0:23 0:38 0:32 0:14 1:06 0:40 0:34 0:14 0:19 0:73
M DD 0:43 0:16 0:12 0:40 0:08 0:31 0:13 0:15 0:29 0:10
AC1 0:22 0:09 0:01 0:18 0:09 0:17 0:10 0:12 0:25 0:10

37
Table 4. Volatility Risk Premia Portfolios

This table presents descriptive statistics of …ve currency portfolios sorted on the 1-year volatility risk
premia at time t 1. The long (short) portfolio PL (PS ) contains the top 20% of all currencies with the
highest (lowest) volatility risk premia. H=L denotes a long-short strategy that buys PL and sells PS . The
table also reports the …rst order autocorrelation coe¢ cient (AC1 ), the annualized Sharpe ratio (SR), and the
frequency of portfolio switches (F req). Panel A displays the overall excess return, whereas Panel B reports
the exchange rate component only. Panel C presents the transition probability from portfolio i to portfolio j
between time t and time t + 1. indicates the steady state probability. Returns are expressed in percentage
per annum. The strategies are rebalanced monthly from January 1996 to August 2011. Exchange rates are
from Datastream whereas implied volatility quotes are proprietary data from JP Morgan.

Panel A: Excess Returns


PL P2 P3 P4 PS H=L PL P2 P3 P4 PS H=L
Developed Developed & Emerging
M ean 4:70 2:24 1:04 1:78 0:67 4:03 3:59 1:93 1:34 1:40 1:26 2:34
Sdev 9:08 9:27 9:76 10:07 9:72 8:33 9:32 8:68 8:89 10:44 8:81 8:18
Skew 0:05 0:19 0:09 0:17 0:26 0:28 0:09 0:05 0:21 0:29 0:39 0:12
Kurt 3:13 5:14 5:80 3:85 3:82 3:47 3:09 4:79 3:85 4:16 3:73 3:26
SR 0:52 0:24 0:11 0:18 0:07 0:48 0:39 0:22 0:15 0:13 0:14 0:29
AC1 0:10 0:04 0:13 0:15 0:01 0:04 0:10 0:14 0:15 0:13 0:11 0:05
F req 0:24 0:44 0:52 0:48 0:32 0:32 0:26 0:43 0:53 0:48 0:27 0:27
Panel B: FX Returns
M ean 4:93 2:06 1:26 1:60 0:52 4:40 3:51 1:62 1:37 0:82 0:21 3:72
Sdev 9:05 9:24 9:63 9:96 9:64 8:35 9:26 8:62 8:74 10:31 8:75 8:17
Skew 0:12 0:15 0:06 0:18 0:26 0:28 0:18 0:00 0:26 0:31 0:47 0:12
Kurt 3:17 5:24 5:88 4:06 3:83 3:61 3:07 4:80 4:02 4:36 3:94 3:50
SR 0:54 0:22 0:13 0:16 0:05 0:53 0:38 0:19 0:16 0:08 0:02 0:46
AC1 0:10 0:03 0:11 0:13 0:01 0:04 0:10 0:13 0:13 0:10 0:10 0:04
F req 0:24 0:44 0:52 0:48 0:32 0:32 0:26 0:43 0:53 0:48 0:27 0:27
Panel C: Transition Matrix
PL 0:77 0:18 0:03 0:01 0:01 0:75 0:20 0:03 0:01 0:01
P2 0:17 0:56 0:20 0:06 0:02 0:16 0:57 0:20 0:05 0:02
P3 0:03 0:20 0:49 0:20 0:08 0:03 0:22 0:48 0:22 0:05
P4 0:01 0:05 0:21 0:52 0:21 0:01 0:08 0:23 0:52 0:16
PS 0:00 0:02 0:08 0:21 0:69 0:01 0:02 0:05 0:19 0:73
0:19 0:20 0:20 0:20 0:20 0:19 0:23 0:20 0:19 0:18

38
Table 5. Exchange Rate Returns and Risk Factors

This table presents time-series regression estimates. The dependent variable is the volatility risk premium
strategy (V RP ) that buys (sells) currencies with the highest (lowest) 1-year volatility risk premium. As
explanatory variables, we use the currency strategies decribed in Table 2 in Panel A, the Fama and French
(1992) and the equity momentum factors in Panel B, and the Fung and Hsieh (2001) factors in Panel C. Newey
and West (1987) with Andrews (1991) optimal lag selection are reported in parenthesis. The superscripts a, b,
and c indicate statistical signi…cance at 10%, 5%, and 1%, respectively. Returns are annualized. The strategies
are rebalanced monthly from January 1996 to August 2011. Exchange rates are from Datastream whereas
implied volatility quotes are proprietary data from JP Morgan. Fama and French (1992) factors are from
French’s website whereas the Fung and Hsieh (2001) are from Hsieh’s website.

Panel A: Currency Factors


DOL CAR M OM V AL RR R2
Developed
0:05b 0:14 0:22b 0:11 0:10 0:04 0:05
(0:02) (0:09) (0:09) (0:08) (0:13) (0:12)
Developed & Emerging
0:04a 0:04 0:31c 0:09 0:32b 0:08 0:15
(0:02) (0:07) (0:09) (0:08) (0:11) (0:09)
Panel B: Equity Factors
e
Rm SM B HM L M OM E R2
Developed
0:05b 0:07 0:05 0:09a 0:05 0:01
(0:02) (0:06) (0:05) (0:05) (0:03)
Developed & Emerging
0:05b 0:07a 0:10a 0:10b 0:05a 0:03
(0:02) (0:04) (0:05) (0:05) (0:03)
Panel C: Hedge Fund Factors
Bond Curr Comm Equity Size Bond Credit
T rend T rend T rend M arket Spread M arket Spread R2
Developed
0:05b 0:14 0:17 0:09 0:04 0:05 0:09 0:07 0:01
(0:02) (0:12) (0:11) (0:17) (0:05) (0:05) (0:11) (0:21)
Developed & Emerging
0:04b 0:35 0:03 0:08 0:02 0:10b 0:16b 0:07 0:06
(0:02) (0:1) (0:13) (0:16) (0:04) (0:05) (0:07) (0:10)

39
Table 6. Asset Pricing Tests
This table reports asset pricing results. In Panel A the linear factor model includes the dollar (DOL) and the carry trade (CAR) factors. In Panel B
the linear factor model includes the dollar (DOL) and the innovations to the global FX volatility (V OLF X ) factors. CAR is a long-short strategy that
buys (sells) the top 20% of all currencies currencies with the highest (lowest) interest rate di¤erential relative to the US dollar. DOL is equivalent to a
strategy that borrows in the US money market and equally invests in foreign currenies, and serves as a constant in the cross-section. The test assets are
excess returns to …ve portfolios sorted on the 1-year volatility risk premia (V RP ) available at time t 1. Factor Prices reports GMM and Fama-MacBeth
(FMB) estimates of the factor loadings b, the market price of risk . The 2 and the Hansen-Jagannathan distance are test statistics for the null hypothesis
that all pricing errors are jointly zero. Factor Betas reports least-squares estimates of time series regressions. The 2 ( ) test statistic tests the null that
all intercepts are jointly zero. Newey and West (1987) with Andrews (1991) optimal lag selection are reported in parenthesis. sh denotes Shanken (1992)
standard errors. The p-values are reported in brackets. Returns are annualized. The portfolios are rebalanced monthly from January 1996 to August 2011.
Exchange rates are from Datastream whereas implied volatility quotes are proprietary data from JP Morgan.

Panel A: Carry Trade Factor


Factor Prices
2 2
bDOL bCAR DOL CAR R2 RM SE HJ bDOL bCAR DOL CAR R2 RM SE HJ
Developed Developed & Emerging
GM M1 0:42 0:47 0:02 0:05 0:07 3:29 4:35 0:16 0:24 0:01 0:02 0:01 0:14 2:09 1:93 0:11
(0:36) (0:55) (0:02) (0:07) [0:23] [0:20] (0:35) (0:51) (0:02) (0:06) [0:59] [0:59]

40
GM M2 0:35 0:37 0:02 0:03 0:13 3:32 4:30 0:24 0:09 0:02 0:02 0:13 2:10 1:90
(0:36) (0:54) (0:02) (0:07) [0:23] (0:35) (0:50) (0:02) (0:06) [0:59]
F MB 0:42 0:47 0:02 0:05 0:07 3:29 4:35 0:24 0:01 0:02 0:01 0:14 2:09 1:93
(0:37) (0:58) (0:02) (0:07) [0:23] (0:34) (0:52) (0:02) (0:06) [0:59]
(sh) (0:34) (0:61) (0:02) (0:08) [0:18] (0:30) (0:53) (0:02) (0:06) [0:56]
Factor Betas
2 2
DOL CAR R2 ( ) DOL CAR R2 ( )
PL 0:03 0:89 0:04 0:62 8:75 0:02 0:96 0:02 0:69 3:10
(0:02) (0:06) (0:07) [0:12] (0:01) (0:04) (0:05) [0:68]
P2 0:01 0:94 0:04 0:71 0:01 0:96 0:02 0:79
(0:01) (0:08) (0:05) (0:01) (0:04) (0:04)
P3 0:01 1:00 0:05 0:72 0:01 1:00 0:08 0:80
(0:01) (0:05) (0:05) (0:01) (0:04) (0:04)
P4 0:01 1:15 0:15 0:81 0:01 1:20 0:09 0:84
(0:01) (0:05) (0:05) (0:01) (0:05) (0:06)
PS 0:02 1:03 0:08 0:79 0:02 0:87 0:17 0:75
(0:01) (0:04) (0:05) (0:01) (0:05) (0:05)
(continued)
Table 6. Asset Pricing Tests (continued)

Panel B: Global Volatility Factor


Factor Prices
2 2
bDOL bV OLF X DOL V OLF X R2 RM SE HJ bDOL bV OLF X DOL V OLF X R2 RM SE HJ
Developed Developed & Emerging
GM M1 0:52 1:25 0:02 0:16 0:26 2:74 3:02 0:13 0:48 0:55 0:02 0:08 0:07 2:04 2:31 0:11
(0:32) (0:81) (0:02) (0:11) [0:39] [0:44] (0:72) (1:49) (0:02) (0:22) [0:51] [0:55]
GM M2 0:44 1:01 0:02 0:15 0:27 2:75 2:91 0:30 0:13 0:02 0:02 0:14 2:06 2:22
(0:32) (0:78) (0:02) (0:11) [0:41] (0:7) (1:43) (0:02) (0:22) [0:53]
FMB 0:52 1:24 0:02 0:16 0:26 2:74 3:02 0:48 0:55 0:02 0:08 0:07 2:04 2:31
(0:36) (0:81) (0:02) (0:11) [0:39] (0:66) (1:34) (0:02) (0:22) [0:51]
(sh) (0:33) (0:92) (0:02) (0:13) [0:37] (0:71) (1:49) (0:02) (0:25) [0:54]
Factor Betas
2 2
DOL V OLF X R2 ( ) DOL V OLF X R2 ( )
PL 0:03 0:90 0:08 0:62 10:01 0:02 0:97 0:02 0:69 2:94
(0:01) (0:06) (0:06) [0:07] (0:01) (0:05) (0:03) [0:71]

41
P2 0:00 0:94 0:07 0:71 0:00 0:95 0:02 0:79
(0:01) (0:08) (0:05) (0:01) (0:05) (0:03)
P3 0:01 1:02 0:03 0:71 0:01 0:99 0:03 0:79
(0:01) (0:06) (0:07) (0:01) (0:04) (0:02)
P4 0:01 1:10 0:01 0:78 0:01 1:19 0:02 0:83
(0:01) (0:06) (0:04) (0:01) (0:05) (0:04)
PS 0:02 1:04 0:06 0:78 0:01 0:91 0:03 0:71
(0:01) (0:04) (0:04) (0:01) (0:05) (0:03)
Table 7. -Sorted Portfolios: Average Volatility Risk Premia

This table presents descriptive statistics of -sorted currency portfolios. Each is obtained by regressing
individual currency excess returns on the average volatility risk premia using a 36-month moving window. The
long (short) portfolio PL (PS ) contains the top 20% of all currencies with the lowest (highest) . H=L denotes a
long-short strategy that buys PL and sells PS . The table also reports the …rst order autocorrelation coe¢ cient
(AC1 ), the annualized Sharpe ratio (SR), and the frequency of portfolio switches (F req). Panel A displays the
overall excess return, whereas Panel B reports the exchange rate component only. Panel C presents the pre-
and post-formation s, and the pre- and post-formation interest rate di¤erential (if) relative to the US dollar.
Standard deviations are reported in brackets whereas standard errors are reported in parentheses. Returns
are expressed in percentage per annum. The strategies are rebalanced monthly from January 1996 to August
2001. Exchange rates are from Datastream whereas implied volatility quotes are proprietary data from JP
Morgan.

Panel A: Excess Returns


PL P2 P3 P4 PS H=L PL P2 P3 P4 PS H=L
Developed Developed & Emerging
M ean 5:54 1:70 3:46 2:06 6:76 1:23 4:16 2:22 3:33 3:34 5:43 1:27
Sdev 9:50 10:48 9:09 10:17 11:90 10:91 8:61 10:00 9:49 9:97 11:38 10:67
Skew 0:27 0:05 0:52 0:04 0:36 0:80 0:04 0:38 0:29 0:25 0:67 1:14
Kurt 3:04 4:55 5:03 4:53 4:93 6:78 2:35 4:83 4:79 3:99 5:45 8:15
SR 0:58 0:16 0:38 0:20 0:57 0:11 0:48 0:22 0:35 0:33 0:48 0:12
SO 1:11 0:25 0:52 0:30 0:81 0:19 0:88 0:37 0:50 0:49 0:66 0:22
M DD 0:19 0:27 0:31 0:30 0:27 0:35 0:19 0:27 0:32 0:27 0:27 0:35
AC1 0:03 0:01 0:19 0:12 0:10 0:03 0:04 0:05 0:18 0:11 0:12 0:01
F req 0:18 0:25 0:32 0:29 0:09 0:09 0:16 0:18 0:28 0:26 0:10 0:10
Panel B: FX Returns
M ean 6:39 1:91 3:07 1:18 4:69 1:70 5:10 2:35 2:78 1:56 3:21 1:90
Sdev 9:41 10:41 9:06 10:08 11:88 10:97 8:52 9:94 9:44 9:82 11:33 10:72
Skew 0:30 0:04 0:56 0:07 0:38 0:87 0:06 0:37 0:33 0:31 0:76 1:30
Kurt 3:11 4:54 5:15 4:43 4:98 7:02 2:34 4:88 4:84 3:99 5:65 8:75
SR 0:68 0:18 0:34 0:12 0:39 0:15 0:60 0:24 0:29 0:16 0:28 0:18
SO 1:33 0:28 0:46 0:17 0:56 0:28 1:13 0:39 0:42 0:23 0:38 0:35
M DD 0:16 0:25 0:32 0:32 0:29 0:32 0:16 0:25 0:33 0:29 0:29 0:22
AC1 0:02 0:01 0:19 0:12 0:10 0:05 0:04 0:04 0:18 0:09 0:11 0:02
F req 0:18 0:25 0:32 0:29 0:09 0:09 0:16 0:18 0:28 0:26 0:10 0:10
Panel C: Portfolio Formation
pre-if 0:85 0:21 0:39 0:88 2:08 0:94 0:13 0:55 1:78 2:22
post-if 0:85 0:19 0:41 0:90 2:09 0:97 0:10 0:56 1:79 2:24
pre- 0:35 0:14 0:13 0:35 0:60 0:42 0:17 0:12 0:40 0:81
[0:46] [0:50] [0:46] [0:32] [0:32] [0:71] [0:73] [0:61] [0:51] [0:56]
post- 0:26 0:29 0:15 0:06 0:11 0:26 0:22 0:09 0:14 0:08
(0:11) (0:10) (0:08) (0:08) (0:06) (0:09) (0:11) (0:08) (0:06) (0:07)

42
Table 8. Risk Factors: Liquidity and Hedging

This table presents predictive regressions estimates. The dependent variable is the exchange rate return component of the V RP strategy at time t.
This strategy is a long/short portfolio that buys (sells) the top 20% of all currencies with the highest (lowest) 1-year expected volatility premia at time
t 1. The predictors are measured at time t 1, and include the T ED spread, the change in the V IX index, the change in the St.Louis Fed Financial
Stress Index F SI, the net short futures position (HED) of commercial and non-commercial traders on the Australian dollar (AUD) and the Japanese
yen (JPY) vis-a-vis the US dollar (USD), respectively, and the F und F lows constructed as the AUM-weighted net ‡ows into hedge funds (currency and
global macro funds) scaled by the lagged AUM. T ED, V IX, and F SI are averaged on a 12-month rolling window. HED is winsorized at 99%. Newey
and West (1987) with Andrews (1991) optimal lag selection are reported in parenthesis. The superscripts a, b, and c indicate statistical signi…cance at
10%, 5%, and 1%, respectively. Exchange rate returns are annualized. Exchange rates are from Datastream, implied volatility quotes are from JP Morgan,
futures positions are from the US Commodity Futures Trading Commission (CFTC), hedge fund ‡ows are from Patton and Ramadorai (2013), F SI is
from St.Louis Fed’s website, whereas all other data are from Bloomberg.

T ED HED F und T ED HED F und


T ED V IX F SI V IX AU DU SD JP Y U SD F lows R2 T ED V IX F SI V IX AU DU SD JP Y U SD F lows R2
D eveloped D eveloped & E m ergin g
0:04 0:16b 0:03 0:01 0:06 0:00
(0:03) (0:07) (0:03) (0:06)
0:04b 0:05a 0:01 0:04a 0:04 0:01

43
(0:02) (0:03) (0:02) (0:03)
0:04b 0:38b 0:02 0:04a 0:32a 0:01
(0:02) (0:18) (0:02) (0:16)
0:03 0:09c 0:05 0:03 0:06c 0:02
(0:02) (0:02) (0:02) (0:02)
0:05b 0:03c 0:01 0:04a 0:02b 0:01
(0:02) (0:01) (0:02) (0:01)
0:05b 0:02 0:00 0:04a 0:01 0:01
(0:02) (0:06) (0:02) (0:06)
0:05b 1:50b 0:02 0:05b 1:14a 0:01
(0:02) (0:72) (0:02) (0:74)
0:01 0:12 0:02b 0:93 0:04 0:03 0:03 0:02a 0:93 0:01
(0:04) (0:07) (0:01) (0:73) (0:04) (0:07) (0:01) (0:75)
0:05b 0:04 0:02b 1:15a 0:03 0:04b 0:03 0:02b 0:86 0:02
(0:02) (0:03) (0:01) (0:68) (0:02) (0:03) (0:01) (0:67)
0:05b 0:31a 0:02b 1:15a 0:04 0:04b 0:26 0:02b 0:83 0:02
(0:02) (0:18) (0:01) (0:68) (0:02) (0:17) (0:01) (0:69)
0:04a 0:08c 0:02b 0:93 0:06 0:04 0:05c 0:02b 0:72 0:03
(0:02) (0:02) (0:01) (0:65) (0:02) (0:02) (0:01) (0:66)
Table 9. The Behaviour of Order Flow in VRP-sorted Portfolios

This table presents descriptive statistics of currency order ‡ow position associated with the volatility risk
premia (V RP ) strategy. V RP is a strategy that buys (sells) the top 25% of all currencies with the highest
(lowest) 1-year volatility risk premium. We standardize order ‡ow over a rolling window of 63 days prior to
the order ‡ow signal. The table also reports the …rst order autocorrelation coe¢ cient (AC1 ). The strategies
are rebalanced daily from January 2001 to May 2011. Exchange rates are from Datastream, implied volatility
quotes are proprietary data from JP Morgan, whereas order ‡ow data in USD billions are proprietary data
from a major bank.

Panel A: Excess Returns


PL P2 P3 PS
Corporate Clients
M ean 0:052 0:010 0:037 0:080
Sdev 0:817 0:672 0:751 0:730
AC1 0:072 0:058 0:044 0:126

Asset Managers
M ean 0:003 0:006 0:002 0:042
Sdev 0:713 0:628 0:703 0:750
AC1 0:092 0:074 0:014 0:012

Hedge Funds
M ean 0:033 0:009 0:033 0:050
Sdev 0:786 0:640 0:757 0:780
AC1 0:051 0:043 0:033 0:019

Total
M ean 0:054 0:018 0:008 0:019
Sdev 0:715 0:617 0:712 0:758
AC1 0:062 0:052 0:009 0:007

44
45

Figure 1. Rolling Sharpe Ratios

The figure presents the 1-year rolling Sharpe ratios of currency strategies formed using t − 1 information. CAR is the carry trade strategy that buys (sells) the top 20%
of all currencies with the highest (lowest) interest rate differential relative to the US dollar. Similarly, M OM is the momentum strategy that buys (sells) currencies with
the highest (lowest) past 3-month exchange rate return, V AL is the value strategy that buys (sells) currencies with lowest (highest) real exchange rate, RR is the risk
reversal strategy that buys (sells) currencies with the lowest (highest) 1-year risk reversal, and V RP is the volatility risk premium strategy that buys (sells) currencies
with the highest (lowest) 1-year volatility risk premium. The strategies are rebalanced monthly from January 1996 to August 2011, and refer to developed countries.
Exchange rates are from Datastream whereas implied volatility quotes are proprietary data from JP Morgan.
46

Figure 2. Currency Strategies and Payoffs

The figure presents the cumulative wealth to currency strategies formed using t − 1. CAR is the carry trade strategy that buys (sells) the top 20% of all currencies with
the highest (lowest) interest rate differential relative to the US dollar. Similarly, M OM is the momentum strategy that buys (sells) currencies with the highest (lowest)
past 3-month exchange rate return, V AL is the value strategy that buys (sells) currencies with lowest (highest) real exchange rate, RR is the risk reversal strategy that
buys (sells) currencies with the lowest (highest) 1-year risk reversal, and V RP is the volatility risk premium strategy that buys (sells) currencies with the highest (lowest)
1-year volatility risk premium. The strategies are rebalanced monthly from January 1996 to August 20111, and refer to developed countries. Exchange rates are from
Datastream whereas implied volatility quotes are proprietary data from JP Morgan.
47

Figure 3. Returns to VRP and β-sorted Portfolios

The figure presents the cumulative wealth to long (PL ), short (PS ), and long/short (L/S) portfolios. The V RP portfolios are computed by sorting currencies into 5
portfolios using the volatility risk premia at time t − 1: PL (PS ) contains the currencies with the highest (lowest) 1-year volatility risk premium. The β-sorted portfolios
are obtained by regressing individual currency excess returns on the average volatility risk premium using a 36-month moving window: PL (PS ) contains the top 20% of
all currencies with the lowest (highest) β. The strategies are rebalanced monthly from January 1996 to August 20111, and refer to developed countries. Exchange rates
are from Datastream whereas implied volatility quotes are proprietary data from JP Morgan.
48

Figure 4. Reversals in VRP over Longer Horizons

This figure presents cumulative average returns to the long/short V RP strategy after portfolio formation. V RP buys (sells) the top 20% of all currencies with the highest
(lowest) 1-year volatility risk premia known at time t − 1. Post-formation returns are constructed for 1, 2, . . . , 20 months following the formation period. This is equivalent
to building new portfolios every month and recording them for the subsequent 20 months (using overlapping horizons). We cumulate risk-adjusted (with respect to the
carry trade strategy) currency excess returns and exchange rate returns. The strategies are rebalanced monthly from January 1996 to August 2011. Exchange rates are
from Datastream whereas implied volatility quotes are proprietary data from JP Morgan.
49

Figure 5. Order Flow Positions

The figure presents the cumulative daily order flow associated with the volatility risk premium strategy (VRP). PL (PS ) denotes the order flow into the long (short)
portfolio of the V RP strategy. We standardize order flow over a rolling window of 63 days prior to the order flow signal. The strategies are rebalanced daily from January
2001 to May 2011. Exchange rates are from Datastream, implied volatility quotes are proprietary data from JP Morgan, whereas customer order flow data are proprietary
data a major bank.
Web Appendix for:
Volatility Risk Premia and Exchange Rate Predictability
(not for publication)

July 2013

Pasquale DELLA CORTE Tarun RAMADORAI Lucio SARNO

1
A Data Construction for Table 8
Below we provide a detailed description of the predictive variables used in Table 8:

T ED denotes the spread between the 3-month LIBOR and 3-month T-bill. We use the
rolling average over the past 12-month window.

V IX is the change in the VIX index. We use the rolling average over the past 12-month
window.

F SI is the change in the St.Louis Fed Financial Stress index. We use the rolling
average over the past 12-month window.

HED is the net short position on currency futures contracts of commercial (com) and
non-commercial (non) traders. We measure the net position for ech category on the
Australian dollar (AUD) as follows
ShortP ositionnon
t LongP ositionnon
t
HEDtnon =
ShortP ositionnon
t 1 + LongP ositionnon
t 1

ShortP ositioncom
t LongP ositioncom
t
HEDtcom = com com
ShortP ositiont 1 + LongP ositiont 1
where the normalization means that the net positions are measured relative to the ag-
gregate open interest of commercial and non-commercial traders in the previous period,
respectively. Note that when the normalizing component is equal to zero, we simply
use previous period non-zero value. The classi…cation used by CFTC to aggregate the
net positions in commercial and non-commercial traders has signi…cant shortcomings.
For instance, a trader with a cash position in the underlying can be categorized as a
commercial trader. This category, however, may include both corporate …rms with an
international line of business as well as banks that have o¤setting positions in the under-
lying foreign currency. Since the de…ning line between commercial and non-commercial
traders is unclear, our measure is constructed as an aggregate measure across both types
of traders as
HEDt = HEDtnon + HEDtcom

Finally, we winsorize HEDt at 99%. We also construct the net position on the Japanese
yen (JPY) relative to the US dollar in a similar manner.

2
F und F lows denotes capital ‡ows into hedge funds. We measure it as the AUM-weighted
net ‡ow of currency and global macro funds scaled by the lagged AUM. Speci…cally, we
employ the AUM and the returns for 634 currency and global macro funds from Patton
and Ramadorai (2013). For each fund i, we measure time-t net ‡ow as follows

F lowti = AU Mti AU Mti 1 1 + rti :

We then construct the AUM-weighted net ‡ow scaled by the lagged AUM as

P F lowti
F lowt = wti 1
i=1 AU Mti 1

where
AU Mti 1
wti 1 =P i
i AU Mt 1

and indicates the available number of hedge funds at time t.

3
Table 1. Volatility Risk Premia

This table presents summary statistics for the 1-year volatility risk premia (Panel A) and the 1-year realized volatility premia (Panel B ). RVt (RVt+ )
denotes the 1-year realized volatility computed between times t and t (t and t + ). indicates the number of trading days in a calendat year. SWt is
constructed at time t using the 1-year implied volatilities across 5 di¤erent deltas from the foreign exchange option market. Qj refers to the j th percentile.
AC indicates the th -order autocorrelation coe¢ cient. Premia are expressed in percentage per annum. The sample period comprises daily data from
January 1996 to August 2011. Exchange rates are from Datastream whereas implied volatility quotes are proprietary data from JP Morgan.

Panel A: Volatility Risk Premium (RVt SWt ) Panel B: Realized Volatility Premia (RVt+ SWt )
M ean M ed Sdev Skew Kurt Q5 Q95 AC M ean M ed Sdev Skew Kurt Q5 Q95 AC
AU D 0:39 0:21 2:43 1:79 9:51 3:08 4:19 0:14 0:84 0:27 4:61 1:37 5:49 5:13 12:56 0:02
CAD 0:59 0:61 1:29 0:16 4:85 2:34 1:45 0:22 0:26 0:65 2:78 0:46 4:01 5:02 4:96 0:15
CHF 0:51 0:47 1:53 0:10 3:12 2:97 1:78 0:20 0:17 0:64 2:23 0:72 3:28 3:16 4:48 0:13
DKK 1:25 1:02 1:66 0:61 4:90 3:89 0:74 0:13 1:04 1:28 2:38 0:60 4:13 4:30 4:11 0:09
EU R 1:16 0:75 1:75 0:73 4:55 4:30 0:78 0:12 1:00 1:23 2:49 0:54 4:14 4:49 4:78 0:09
GBP 1:15 1:36 1:76 0:23 6:52 3:54 1:17 0:07 1:01 1:02 2:91 1:18 5:90 5:21 4:55 0:07
JP Y 0:45 0:52 1:72 0:30 3:30 3:14 1:75 0:03 0:57 0:61 3:18 0:28 2:46 5:11 5:29 0:26
N OK 0:73 0:58 2:03 0:74 5:19 3:83 2:24 0:14 0:32 0:70 3:16 1:17 4:97 4:61 7:02 0:05
N ZD 0:11 0:40 2:07 0:74 5:37 3:21 4:38 0:09 0:47 0:31 3:81 0:59 3:18 4:80 7:15 0:08
SEK 0:70 0:76 2:22 1:13 7:33 3:69 3:52 0:34 0:26 0:73 3:09 2:33 9:78 3:58 7:39 0:04
4

BRL 3:78 4:04 5:60 0:29 5:03 13:28 7:14 0:15 4:48 4:96 9:12 0:14 3:49 19:68 13:32 0:05
CZK 0:68 0:60 2:61 1:22 6:63 4:61 5:77 0:35 0:21 0:96 4:28 0:86 5:17 5:12 9:54 0:16
HU F 2:21 2:29 2:85 0:31 6:43 6:96 2:27 0:34 1:22 1:77 5:37 0:66 4:53 9:30 11:55 0:31
KRW 1:68 1:59 4:39 0:35 11:47 7:54 5:25 0:23 1:47 2:24 8:79 1:04 5:88 13:89 21:41 0:22
M XN 5:47 3:96 4:93 1:50 6:45 15:40 0:77 0:34 5:43 4:74 7:27 0:09 5:10 18:81 11:16 0:09
P LN 1:73 1:66 3:39 0:05 5:52 7:39 3:96 0:06 0:98 1:52 5:88 1:53 6:14 8:14 15:20 0:10
SGD 1:40 1:13 1:47 2:03 9:06 4:27 0:23 0:17 1:02 0:81 1:99 1:34 5:99 5:16 2:02 0:15
T RY 4:59 4:84 2:90 0:84 4:28 8:51 1:95 0:04 4:77 5:14 5:16 0:36 2:23 12:38 4:33 0:37
TWD 2:34 2:10 1:86 1:00 4:23 5:65 0:03 0:23 2:30 1:95 2:20 0:83 3:33 6:76 0:69 0:03
ZAR 2:57 2:42 3:49 0:12 3:63 8:24 4:77 0:07 2:01 2:71 6:08 0:04 2:69 12:26 8:35 0:20
M ean 1:64 1:55 2:60 0:01 5:87 5:79 2:63 0:06 1:36 1:71 4:34 0:59 4:59 7:85 7:99 0:06
Table 2. Currency Strategies: Net of Bid-Ask

This table presents descriptive statistics of currency strategies formed using time t 1 information. CAR
is the carry trade strategy that buys (sells) the top 20% of all currencies with the highest (lowest) interest
rate di¤erential relative to the US dollar. Similarly, M OM is the momentum strategy that buys (sells)
currencies with the highest (lowest) past 3-month exchange rate return, V AL is the value strategy that buys
(sells) currencies with lowest (highest) real exchange rate, RR is the risk reversal strategy that buys (sells)
currencies with the lowest (highest) 1-year risk reversal, and V RP is the volatility risk premium strategy
that buys (sells) currencies with the highest (lowest) 1-year volatility risk premium. The table also reports
the …rst order autocorrelation coe¢ cient (AC1 ), the annualized Sharpe ratio (SR), the Sortino ratio (SO),
the maximum drawdown (M DD), and the frequency of portfolio switches for the long (F reqL ) and the short
(F reqS ) position. Panel A displays the overall currency excess return whereas Panel B reports the exchange
rate return component only. Panel C presents the sample correlations of the currency excess returns. Returns
are expressed in percentage per annum and adjusted for transaction costs. The strategies are rebalanced
monthly from January 1996 to August 2011. Exchange rates are from Datastream whereas implied volatility
quotes are proprietary data from JP Morgan.

Panel A: Excess Returns


CAR M OM V AL RR V RP CAR M OM V AL RR V RP
Developed Developed & Emerging
M ean 5:74 1:87 5:03 4:55 3:31 6:35 1:21 2:50 4:23 1:29
Sdev 10:66 9:55 9:38 11:39 8:33 9:96 8:30 8:90 10:60 8:17
Skew 0:93 0:35 0:26 0:72 0:28 0:94 0:04 0:15 0:15 0:13
Kurt 5:65 3:85 3:49 6:57 3:47 4:55 2:96 3:17 4:45 3:28
SR 0:54 0:20 0:54 0:40 0:40 0:64 0:15 0:28 0:40 0:16
SO 0:64 0:36 0:81 0:50 0:70 0:80 0:25 0:44 0:58 0:26
M DD 0:38 0:19 0:15 0:37 0:21 0:22 0:15 0:15 0:25 0:21
AC1 0:09 0:00 0:03 0:07 0:04 0:01 0:09 0:01 0:08 0:04
F reqL 0:13 0:48 0:09 0:17 0:24 0:15 0:49 0:07 0:22 0:26
F reqS 0:07 0:43 0:07 0:27 0:32 0:16 0:46 0:06 0:26 0:27
Panel B: FX Returns
M ean 0:24 1:63 2:88 1:21 4:17 0:84 0:83 0:02 0:03 3:38
Sdev 10:67 9:58 9:44 11:48 8:35 9:99 8:18 8:89 10:59 8:16
Skew 0:93 0:42 0:29 0:75 0:28 1:04 0:02 0:16 0:21 0:12
Kurt 5:82 4:17 3:51 6:82 3:61 4:83 3:13 3:19 4:73 3:50
SR 0:02 0:17 0:31 0:11 0:50 0:08 0:10 0:00 0:00 0:41
SO 0:03 0:32 0:46 0:13 0:88 0:10 0:17 0:00 0:00 0:68
M DD 0:43 0:21 0:24 0:40 0:19 0:37 0:18 0:28 0:29 0:18
AC1 0:11 0:00 0:02 0:08 0:04 0:03 0:12 0:01 0:08 0:04
F reqL 0:13 0:48 0:09 0:17 0:24 0:15 0:49 0:07 0:22 0:26
F reqS 0:07 0:43 0:07 0:27 0:32 0:16 0:46 0:06 0:26 0:27
Panel C: Correlations
CAR 1:00 0:16 0:44 0:68 0:18 1:00 0:03 0:54 0:57 0:21
M OM 0:16 1:00 0:17 0:17 0:10 0:03 1:00 0:13 0:15 0:10
V AL 0:44 0:17 1:00 0:48 0:23 0:54 0:13 1:00 0:64 0:10
V RP 0:68 0:17 0:48 1:00 0:01 0:57 0:15 0:64 1:00 0:12
RR 0:18 0:10 0:23 0:01 1:00 0:21 0:10 0:10 0:12 1:00

5
Table 3. Currency Strategies: VRP Measures

This table presents descriptive statistics of currency strategies sorted on the 1-year volatility risk premia,
de…ned as the realized volatility (RVt ) minus the synthetic volatility swap rate (SWt ). V RP denotes a strategy
where SWt is computed by interpolating implied volatilities using the cubic spline method (Jiang and Tian,
2005). V RPvv denotes a strategy where SWt is constructed by interpolating implied volatilities using the
vanna-volga method (Castagna and Mercurio, 2007). V RPatm denotes a strategy where SWt is set equal
to the at-the-money implied volatility. V RPsi denotes a strategy where SWt is computed using the simple
variance swap method (Martin, 2012). The table also reports the …rst order autocorrelation coe¢ cient (AC1 ),
the annualized Sharpe ratio (SR), the Sortino ratio (SO), the maximum drawdown (M DD), and the frequency
of portfolio switches for the long (F reqL ) and the short (F reqS ) position. Panel A displays the overall currency
excess return whereas Panel B reports the exchange rate return component only. Panel C presents the sample
correlations of the currency excess returns. Returns are expressed in percentage per annum. The strategies
are rebalanced monthly from January 1996 to August 2011. Exchange rates are from Datastream whereas
implied volatility quotes are proprietary data from JP Morgan.

Panel A: Excess Returns


V RP V RPatm V RPsi V RP V RPatm V RPsi
Developed Developed & Emerging
M ean 4:03 4:35 4:01 2:34 3:05 3:53
Sdev 8:33 8:21 8:24 8:18 8:18 7:95
Skew 0:28 0:04 0:12 0:12 0:02 0:25
Kurt 3:47 3:46 3:34 3:26 3:23 3:32
SR 0:48 0:53 0:49 0:29 0:37 0:44
SO 0:87 0:85 0:82 0:49 0:62 0:82
M DD 0:18 0:21 0:18 0:18 0:20 0:18
AC1 0:04 0:02 0:11 0:05 0:05 0:07
F reqL 0:24 0:26 0:24 0:26 0:25 0:23
F reqS 0:32 0:35 0:33 0:27 0:31 0:28
Panel B: FX Returns
M ean 4:40 4:11 4:00 3:72 3:03 4:05
Sdev 8:35 8:20 8:23 8:17 8:17 7:95
Skew 0:28 0:06 0:09 0:12 0:01 0:24
Kurt 3:61 3:61 3:45 3:50 3:43 3:63
SR 0:53 0:50 0:49 0:46 0:37 0:51
SO 0:93 0:78 0:80 0:75 0:59 0:89
M DD 0:19 0:21 0:19 0:18 0:21 0:19
AC1 0:04 0:02 0:11 0:04 0:04 0:06
F reqL 0:24 0:26 0:24 0:26 0:25 0:23
F reqS 0:32 0:35 0:33 0:27 0:31 0:28
Panel C: Correlations
V RP 1:00 0:84 0:84 1:00 0:82 0:87
V RPatm 0:84 1:00 0:90 0:82 1:00 0:91
V RPsi 0:84 0:90 1:00 0:87 0:91 1:00

6
Table 4. Currency Strategies: NBER Recession Periods

This table presents descriptive statistics of currency strategies formed using time t 1 information.CAR
is the carry trade strategy that buys (sells) the top 20% of all currencies with the highest (lowest) interest
rate di¤erential relative to the US dollar. Similarly, M OM is the momentum strategy that buys (sells)
currencies with the highest (lowest) past 3-month exchange rate return, V AL is the value strategy that buys
(sells) currencies with lowest (highest) real exchange rate, RR is the risk reversal strategy that buys (sells)
currencies with the lowest (highest) 1-year risk reversal, and V RP is the volatility risk premium strategy
that buys (sells) currencies with the highest (lowest) 1-year volatility risk premium. The table also reports
the …rst order autocorrelation coe¢ cient (AC1 ), the annualized Sharpe ratio (SR), the Sortino ratio (SO),
the maximum drawdown (M DD), and the frequency of portfolio switches for the long (F reqL ) and the short
(F reqS ) position. Newey and West (1987) standard errors with Andrews (1991) optimal lag selection are
reported in parenthesis. Panel A displays the overall currency excess return whereas Panel B reports the
exchange rate return component only. Returns are expressed in percentage per annum. The strategies are
rebalanced monthly from March 2001 to November 2001, and from December 2007 to June 2009. Exchange
rates are from Datastream whereas implied volatility quotes are proprietary data from JP Morgan.

Panel A: Excess Returns


CAR M OM V AL RR V RP CAR M OM V AL RR V RP
Developed Developed & Emerging
M ean 3:81 10:78 6:85 3:92 11:98 2:23 7:20 4:93 1:91 4:64
Sdev 16:85 15:20 11:91 18:76 9:92 14:46 10:58 9:95 15:16 9:35
Skew 0:46 0:18 0:64 0:89 0:14 0:74 0:10 0:24 0:02 0:49
Kurt 3:69 2:79 3:42 4:13 2:32 2:73 2:67 3:06 2:63 2:78
SR 0:23 0:71 0:58 0:21 1:21 0:15 0:68 0:50 0:13 0:50
SO 0:32 1:45 0:80 0:24 3:14 0:19 1:29 0:75 0:20 0:71
M DD 0:34 0:16 0:11 0:37 0:08 0:21 0:06 0:14 0:24 0:10
AC1 0:35 0:10 0:09 0:22 0:24 0:16 0:04 0:09 0:30 0:21
F reqL 0:13 0:52 0:11 0:21 0:38 0:12 0:43 0:06 0:17 0:33
F reqS 0:02 0:32 0:02 0:25 0:29 0:14 0:43 0:01 0:33 0:19
Panel B: FX Returns
M ean 9:59 11:32 4:62 7:96 11:54 7:97 7:07 0:10 4:80 6:50
Sdev 17:11 15:40 12:03 19:07 10:11 14:69 10:49 9:92 15:20 9:38
Skew 0:44 0:28 0:63 0:90 0:12 0:80 0:17 0:15 0:08 0:45
Kurt 3:71 2:87 3:43 4:13 2:26 2:84 2:77 2:95 2:54 2:88
SR 0:56 0:74 0:38 0:42 1:14 0:54 0:67 0:01 0:32 0:69
SO 0:75 1:57 0:54 0:48 3:01 0:66 1:26 0:02 0:49 0:94
M DD 0:40 0:16 0:12 0:41 0:09 0:32 0:07 0:18 0:29 0:09
AC1 0:35 0:12 0:09 0:23 0:27 0:17 0:04 0:09 0:31 0:22
F reqL 0:13 0:52 0:11 0:21 0:38 0:12 0:43 0:06 0:17 0:33
F reqS 0:02 0:32 0:02 0:25 0:29 0:14 0:43 0:01 0:33 0:19
Panel C: Correlations
CAR 1:00 0:63 0:53 0:90 0:22 1:00 0:28 0:69 0:80 0:26
M OM 0:63 1:00 0:52 0:46 0:10 0:28 1:00 0:51 0:31 0:18
V AL 0:53 0:52 1:00 0:39 0:23 0:69 0:51 1:00 0:77 0:28
RR 0:90 0:46 0:39 1:00 0:23 0:80 0:31 0:77 1:00 0:46
V RP 0:22 0:10 0:23 0:23 1:00 0:26 0:18 0:28 0:46 1:00

7
Table 5. Currency Strategies: non-NBER Recession Periods

This table presents descriptive statistics of currency strategies formed using time t 1 information. CAR
is the carry trade strategy that buys (sells) the top 20% of all currencies with the highest (lowest) interest
rate di¤erential relative to the US dollar. Similarly, M OM is the momentum strategy that buys (sells)
currencies with the highest (lowest) past 3-month exchange rate return, V AL is the value strategy that buys
(sells) currencies with lowest (highest) real exchange rate, RR is the risk reversal strategy that buys (sells)
currencies with the lowest (highest) 1-year risk reversal, and V RP is the volatility risk premium strategy
that buys (sells) currencies with the highest (lowest) 1-year volatility risk premium. The table also reports
the …rst order autocorrelation coe¢ cient (AC1 ), the annualized Sharpe ratio (SR), the Sortino ratio (SO),
the maximum drawdown (M DD), and the frequency of portfolio switches for the long (F reqL ) and the
short (F reqS ) position. Newey and West (1987) standard errors with Andrews (1991) optimal lag selection
are reported in parenthesis. Panel A displays the overall currency excess return whereas Panel B reports
the exchange rate return component only. Returns are expressed in percentage per annum. The strategies
are rebalanced monthly from January 1996 to February 2001, from December 2001 to November 2007, and
from July 2009 to August 2011. Exchange rates are from Datastream whereas implied volatility quotes are
proprietary data from JP Morgan.

Panel A: Excess Returns


CAR M OM V AL RR V RP CAR M OM V AL RR V RP
Developed Developed & Emerging
M ean 8:31 1:14 5:59 6:92 2:64 8:34 1:35 3:31 5:99 1:93
Sdev 9:13 8:17 8:91 9:55 7:99 8:99 7:84 8:73 9:63 7:99
Skew 0:84 0:09 0:11 0:10 0:25 0:83 0:17 0:13 0:16 0:27
Kurt 4:43 2:43 3:29 3:92 3:77 4:71 2:76 3:18 4:96 3:42
SR 0:91 0:14 0:63 0:72 0:33 0:93 0:17 0:38 0:62 0:24
SO 1:15 0:26 0:99 1:18 0:55 1:25 0:29 0:60 0:93 0:43
M DD 0:13 0:17 0:14 0:14 0:14 0:13 0:14 0:14 0:15 0:19
AC1 0:09 0:06 0:03 0:04 0:03 0:07 0:11 0:01 0:02 0:00
F reqL 0:14 0:48 0:09 0:17 0:21 0:16 0:50 0:07 0:23 0:24
F reqS 0:08 0:45 0:08 0:27 0:32 0:16 0:46 0:07 0:25 0:28
Panel B: FX Returns
M ean 2:09 0:40 2:65 3:08 3:14 0:64 0:46 0:05 1:11 3:23
Sdev 9:06 8:11 8:95 9:57 7:99 8:92 7:68 8:73 9:61 7:96
Skew 0:87 0:04 0:16 0:11 0:26 0:92 0:19 0:16 0:17 0:26
Kurt 4:50 2:48 3:30 4:16 4:02 4:90 2:90 3:22 5:55 3:70
SR 0:23 0:05 0:30 0:32 0:39 0:07 0:06 0:01 0:12 0:41
SO 0:29 0:09 0:45 0:50 0:65 0:09 0:10 0:01 0:16 0:70
M DD 0:31 0:21 0:22 0:15 0:16 0:31 0:20 0:22 0:20 0:16
AC1 0:07 0:09 0:02 0:04 0:03 0:06 0:15 0:00 0:02 0:02
F reqL 0:14 0:48 0:09 0:17 0:21 0:16 0:50 0:07 0:23 0:24
F reqS 0:08 0:45 0:08 0:27 0:32 0:16 0:46 0:07 0:25 0:28
Panel C: Correlations
CAR 1:00 0:12 0:42 0:54 0:16 1:00 0:06 0:50 0:47 0:20
M OM 0:12 1:00 0:02 0:02 0:08 0:06 1:00 0:04 0:09 0:18
V AL 0:42 0:02 1:00 0:55 0:23 0:50 0:04 1:00 0:62 0:06
RR 0:54 0:02 0:55 1:00 0:10 0:47 0:09 0:62 1:00 0:01
V RP 0:16 0:08 0:23 0:10 1:00 0:20 0:18 0:06 0:01 1:00

8
Table 6. Currency Strategies: Pre-Crisis Period

This table presents descriptive statistics of currency strategies formed using time t 1 information. CAR
is the carry trade strategy that buys (sells) the top 20% of all currencies with the highest (lowest) interest
rate di¤erential relative to the US dollar. Similarly, M OM is the momentum strategy that buys (sells)
currencies with the highest (lowest) past 3-month exchange rate return, V AL is the value strategy that buys
(sells) currencies with lowest (highest) real exchange rate, RR is the risk reversal strategy that buys (sells)
currencies with the lowest (highest) 1-year risk reversal, and V RP is the volatility risk premium strategy
that buys (sells) currencies with the highest (lowest) 1-year volatility risk premium. The table also reports
the …rst order autocorrelation coe¢ cient (AC1 ), the annualized Sharpe ratio (SR), the Sortino ratio (SO),
the maximum drawdown (M DD), and the frequency of portfolio switches for the long (F reqL ) and the short
(F reqS ) position. Newey and West (1987) standard errors with Andrews (1991) optimal lag selection are
reported in parenthesis. Panel A displays the overall currency excess return whereas Panel B reports the
exchange rate return component only. Returns are expressed in percentage per annum. The strategies are
rebalanced monthly from January 1996 to December 2006. Exchange rates are from Datastream whereas
implied volatility quotes are proprietary data from JP Morgan.

Panel A: Excess Returns


CAR M OM V AL RR V RP CAR M OM V AL RR V RP
Developed Developed & Emerging
M ean 8:64 1:48 6:92 6:53 1:82 8:61 1:39 4:06 5:55 2:52
Sdev 8:42 7:99 9:68 9:40 7:98 9:22 7:86 9:23 10:10 8:51
Skew 0:86 0:07 0:31 0:28 0:11 0:98 0:06 0:23 0:22 0:18
Kurt 4:84 2:42 3:31 3:93 3:37 5:01 2:44 3:07 4:88 3:23
SR 1:03 0:19 0:71 0:69 0:23 0:93 0:18 0:44 0:55 0:30
SO 1:34 0:35 1:07 1:23 0:38 1:19 0:34 0:66 0:79 0:51
M DD 0:13 0:14 0:14 0:14 0:18 0:13 0:12 0:14 0:16 0:16
AC1 0:06 0:09 0:05 0:03 0:01 0:10 0:10 0:03 0:03 0:01
F reqL 0:16 0:49 0:06 0:22 0:23 0:19 0:51 0:05 0:25 0:25
F reqS 0:09 0:44 0:07 0:33 0:32 0:18 0:45 0:07 0:31 0:28
Panel B: Rate Returns
M ean 1:91 0:81 3:00 2:94 2:18 1:09 0:71 0:58 1:28 3:04
Sdev 8:33 7:90 9:78 9:43 7:99 9:16 7:68 9:25 10:12 8:53
Skew 0:91 0:02 0:31 0:32 0:07 1:06 0:01 0:25 0:24 0:19
Kurt 4:92 2:46 3:26 4:14 3:46 5:20 2:59 3:10 5:41 3:47
SR 0:23 0:10 0:31 0:31 0:27 0:12 0:09 0:06 0:13 0:36
SO 0:30 0:19 0:46 0:52 0:44 0:15 0:17 0:09 0:17 0:59
M DD 0:31 0:16 0:24 0:15 0:19 0:31 0:14 0:23 0:18 0:18
AC1 0:05 0:11 0:03 0:02 0:01 0:08 0:14 0:02 0:03 0:02
F reqL 0:16 0:49 0:06 0:22 0:23 0:19 0:51 0:05 0:25 0:25
F reqS 0:09 0:44 0:07 0:33 0:32 0:18 0:45 0:07 0:31 0:28
Panel C: Correlations
CAR 1:00 0:12 0:58 0:40 0:06 1:00 0:07 0:54 0:42 0:09
M OM 0:12 1:00 0:04 0:03 0:07 0:07 1:00 0:01 0:10 0:08
V AL 0:58 0:04 1:00 0:71 0:28 0:54 0:01 1:00 0:65 0:07
RR 0:40 0:03 0:71 1:00 0:30 0:42 0:10 0:65 1:00 0:11
V RP 0:06 0:07 0:28 0:30 1:00 0:09 0:08 0:07 0:11 1:00

9
Table 7. Currency Strategies: Crisis Period

This table presents descriptive statistics of currency strategies formed using time t 1 information. CAR
is the carry trade strategy that buys (sells) the top 20% of all currencies with the highest (lowest) interest
rate di¤erential relative to the US dollar. Similarly, M OM is the momentum strategy that buys (sells)
currencies with the highest (lowest) past 3-month exchange rate return, V AL is the value strategy that buys
(sells) currencies with lowest (highest) real exchange rate, RR is the risk reversal strategy that buys (sells)
currencies with the lowest (highest) 1-year risk reversal, and V RP is the volatility risk premium strategy
that buys (sells) currencies with the highest (lowest) 1-year volatility risk premium. The table also reports
the …rst order autocorrelation coe¢ cient (AC1 ), the annualized Sharpe ratio (SR), the Sortino ratio (SO),
the maximum drawdown (M DD), and the frequency of portfolio switches for the long (F reqL ) and the short
(F reqS ) position. Newey and West (1987) standard errors with Andrews (1991) optimal lag selection are
reported in parenthesis. Panel A displays the overall currency excess return whereas Panel B reports the
exchange rate return component only. Returns are expressed in percentage per annum. The strategies are
rebalanced monthly from January 2007 to August 2011. Exchange rates are from Datastream whereas implied
volatility quotes are proprietary data from JP Morgan.

Panel A: Excess Returns


CAR M OM V AL RR V RP CAR M OM V AL RR V RP
Developed Developed & Emerging
M ean 1:47 5:15 3:11 2:42 9:22 4:65 4:18 2:35 4:98 1:90
Sdev 14:62 12:53 8:67 15:15 9:01 11:59 9:30 8:14 11:78 7:43
Skew 0:63 0:37 0:16 1:10 0:46 0:75 0:22 0:11 0:02 0:11
Kurt 3:95 3:40 4:15 5:55 3:26 3:59 3:47 3:45 3:64 3:14
SR 0:10 0:41 0:36 0:16 1:02 0:40 0:45 0:29 0:42 0:26
SO 0:13 0:77 0:56 0:17 2:20 0:51 0:67 0:50 0:65 0:42
M DD 0:37 0:16 0:12 0:37 0:10 0:21 0:13 0:14 0:24 0:12
AC1 0:21 0:07 0:02 0:17 0:10 0:16 0:08 0:13 0:25 0:14
F reqL 0:07 0:46 0:16 0:06 0:27 0:07 0:46 0:10 0:14 0:28
F reqS 0:04 0:41 0:05 0:12 0:31 0:11 0:46 0:03 0:15 0:23
Panel B: FX Returns
M ean 3:34 4:88 2:81 2:13 9:61 4:73 3:17 1:15 2:25 5:30
Sdev 14:80 12:69 8:67 15:31 9:05 11:70 9:23 8:05 11:72 7:29
Skew 0:66 0:50 0:22 1:13 0:54 0:89 0:10 0:12 0:12 0:07
Kurt 4:02 3:57 4:27 5:63 3:42 3:90 3:56 3:41 3:67 3:39
SR 0:23 0:38 0:32 0:14 1:06 0:40 0:34 0:14 0:19 0:73
SO 0:28 0:75 0:50 0:15 2:38 0:50 0:51 0:24 0:28 1:18
M DD 0:43 0:16 0:12 0:40 0:08 0:31 0:13 0:15 0:29 0:10
AC1 0:22 0:09 0:01 0:18 0:09 0:17 0:10 0:12 0:25 0:10
F reqL 0:07 0:46 0:16 0:06 0:27 0:07 0:46 0:10 0:14 0:28
F reqS 0:04 0:41 0:05 0:12 0:31 0:11 0:46 0:03 0:15 0:23
Panel C: Correlations
CAR 1:00 0:41 0:27 0:91 0:47 1:00 0:19 0:56 0:81 0:48
M OM 0:41 1:00 0:39 0:31 0:12 0:19 1:00 0:41 0:24 0:17
V AL 0:27 0:39 1:00 0:17 0:13 0:56 0:41 1:00 0:66 0:62
RR 0:91 0:31 0:17 1:00 0:41 0:81 0:24 0:66 1:00 0:65
V RP 0:47 0:12 0:13 0:41 1:00 0:48 0:17 0:62 0:65 1:00

10
Table 8. Carry Trade Portfolios

This table presents descriptive statistics of …ve currency portfolios sorted on the 1-year volatility risk premia V RP at time t 1. The long (short)
portfolio PL (PS ) contains the top 20% of all currencies with the highest (lowest) volatility risk premia. DOL is the average of the currency portfolios.
H=L is a long-short strategy that buys PL and sells PS . The table also reports the …rst order autocorrelation coe¢ cient (AC1 ), the annualized Sharpe
ratio (SR), the Sortino ratio (SO), the maximum drawdown (M DD), and the frequency of portfolio switches (F req). Newey and West (1987) standard
errors with Andrews (1991) optimal lag selection are reported in parenthesis. Panel A displays the overall currency excess return, whereas Panel B reports
only the exchange rate component. Returns are expressed in percentage per annum. The strategies are rebalanced monthly from January 1996 to August
2011. Exchange rates are from Datastream whereas implied volatility quotes are proprietary data from JP Morgan.

Panel A: Excess Returns


PL P2 P3 P4 PS H=L PL P2 P3 P4 PS H=L
Developed Developed & Emerging
M ean 6:31 3:00 1:82 0:06 0:18 6:49 6:07 3:34 2:34 0:61 1:36 7:42
Sdev 10:97 9:19 9:23 9:21 9:21 10:66 10:43 9:68 9:54 8:38 8:63 9:97
Skew 0:17 0:53 0:02 0:15 0:63 0:92 0:48 0:82 0:29 0:03 0:59 0:92
Kurt 5:06 6:47 4:26 3:70 3:88 5:65 5:02 6:43 4:89 3:66 4:49 4:53
SR 0:58 0:33 0:20 0:01 0:02 0:61 0:58 0:35 0:24 0:07 0:16 0:74
11

AC1 0:16 0:08 0:11 0:12 0:03 0:09 0:23 0:08 0:17 0:08 0:02 0:01
F req 0:13 0:21 0:29 0:23 0:07 0:07 0:15 0:20 0:26 0:28 0:16 0:16
Panel B: FX Returns
M ean 3:10 1:94 1:96 0:87 2:76 0:34 1:12 1:56 2:21 0:33 1:77 0:65
Sdev 10:90 9:14 9:16 9:13 9:11 10:66 10:33 9:64 9:46 8:34 8:54 9:99
Skew 0:20 0:55 0:02 0:18 0:66 0:93 0:63 0:92 0:34 0:05 0:65 1:05
Kurt 5:18 6:48 4:26 3:66 3:97 5:82 5:34 6:80 4:98 3:67 4:73 4:84
SR 0:28 0:21 0:21 0:10 0:30 0:03 0:11 0:16 0:23 0:04 0:21 0:07
AC1 0:16 0:07 0:10 0:11 0:01 0:11 0:23 0:08 0:16 0:07 0:00 0:03
F req 0:13 0:21 0:29 0:23 0:07 0:07 0:15 0:20 0:26 0:28 0:16 0:16
Panel C: Transition Matrix
PL 0:87 0:09 0:03 0:01 0:01 0:85 0:10 0:03 0:01 0:01
P2 0:07 0:80 0:10 0:03 0:00 0:08 0:80 0:09 0:03 0:00
P3 0:02 0:10 0:71 0:15 0:02 0:02 0:10 0:75 0:11 0:02
P4 0:01 0:03 0:14 0:78 0:04 0:01 0:04 0:09 0:73 0:12
PS 0:00 0:00 0:02 0:04 0:94 0:00 0:00 0:03 0:11 0:85
0:18 0:21 0:21 0:21 0:20 0:17 0:24 0:20 0:19 0:20
Table 9. Momentum Portfolios

This table presents descriptive statistics of …ve currency portfolios sorted on the 1-year volatility risk premia V RP at time t 1. The long (short)
portfolio PL (PS ) contains the top 20% of all currencies with the highest (lowest) volatility risk premia. DOL is the average of the currency portfolios.
H=L is a long-short strategy that buys PL and sells PS . The table also reports the …rst order autocorrelation coe¢ cient (AC1 ), the annualized Sharpe
ratio (SR), the Sortino ratio (SO), the maximum drawdown (M DD), and the frequency of portfolio switches (F req). Newey and West (1987) standard
errors with Andrews (1991) optimal lag selection are reported in parenthesis. Panel A displays the overall currency excess return, whereas Panel B reports
only the exchange rate component. Returns are expressed in percentage per annum. The strategies are rebalanced monthly from January 1996 to August
2011. Exchange rates are from Datastream whereas implied volatility quotes are proprietary data from JP Morgan.

Panel A: Excess Returns


PL P2 P3 P4 PS H=L PL P2 P3 P4 PS H=L
Developed Developed & Emerging
M ean 2:93 2:31 0:79 3:33 0:34 2:58 2:10 3:06 0:56 3:32 0:13 2:22
Sdev 9:60 9:42 8:97 10:22 10:00 9:55 9:31 9:13 9:19 9:45 9:61 8:30
Skew 0:39 0:01 0:14 0:19 0:11 0:35 0:10 0:04 0:57 0:15 0:03 0:03
Kurt 4:06 4:81 4:00 4:81 6:11 3:86 3:36 3:78 4:88 5:84 4:09 2:95
SR 0:30 0:25 0:09 0:33 0:03 0:27 0:23 0:34 0:06 0:35 0:01 0:27
12

AC1 0:09 0:02 0:12 0:14 0:12 0:00 0:18 0:05 0:15 0:12 0:08 0:09
F req 0:48 0:66 0:68 0:63 0:43 0:43 0:49 0:66 0:68 0:68 0:46 0:46
Panel B: FX Returns
M ean 2:62 1:76 0:84 3:76 0:59 2:03 1:07 2:25 0:25 3:23 0:38 1:45
Sdev 9:46 9:33 8:91 10:15 9:92 9:57 9:17 9:01 9:14 9:35 9:48 8:16
Skew 0:41 0:03 0:15 0:16 0:15 0:42 0:19 0:03 0:63 0:17 0:10 0:02
Kurt 4:20 4:96 3:93 5:02 6:31 4:17 3:64 3:84 5:08 6:21 4:15 3:13
SR 0:28 0:19 0:09 0:37 0:06 0:21 0:12 0:25 0:03 0:35 0:04 0:18
AC1 0:07 0:03 0:12 0:13 0:11 0:00 0:16 0:05 0:14 0:11 0:06 0:12
F req 0:48 0:66 0:68 0:63 0:43 0:43 0:49 0:66 0:68 0:68 0:46 0:46
Panel C: Transition Matrix
PL 0:52 0:24 0:13 0:07 0:05 0:51 0:28 0:12 0:05 0:04
P2 0:22 0:34 0:24 0:12 0:08 0:22 0:35 0:25 0:13 0:06
P3 0:10 0:23 0:33 0:22 0:12 0:09 0:25 0:32 0:23 0:11
P4 0:07 0:15 0:22 0:37 0:19 0:07 0:17 0:21 0:32 0:23
PS 0:05 0:07 0:10 0:22 0:58 0:03 0:08 0:10 0:25 0:55
0:19 0:20 0:20 0:20 0:20 0:18 0:23 0:20 0:20 0:20
Table 10. Value Portfolios

This table presents descriptive statistics of …ve currency portfolios sorted on the 1-year volatility risk premia V RP at time t 1. The long (short)
portfolio PL (PS ) contains the top 20% of all currencies with the highest (lowest) volatility risk premia. DOL is the average of the currency portfolios.
HM L is a long-short strategy that buys PL and sells PS . The table also reports the …rst order autocorrelation coe¢ cient (AC1 ), the annualized Sharpe
ratio (SR), the Sortino ratio (SO), the maximum drawdown (M DD), and the frequency of portfolio switches (F req). Newey and West (1987) standard
errors with Andrews (1991) optimal lag selection are reported in parenthesis. Panel A displays the overall currency excess return, whereas Panel B reports
only the exchange rate component. Returns are expressed in percentage per annum. The strategies are rebalanced monthly from January 1996 to August
2011. Exchange rates are from Datastream whereas implied volatility quotes are proprietary data from JP Morgan.

Panel A: Excess Returns


PL P2 P3 P4 PS H=L PL P2 P3 P4 PS H=L
Developed Developed & Emerging
M ean 5:29 0:35 3:39 1:79 0:48 5:78 3:25 1:71 3:34 1:48 0:68 3:93
Sdev 10:11 8:16 9:31 9:36 10:58 9:38 9:10 9:19 8:70 9:22 9:81 8:99
Skew 0:33 0:19 0:06 0:09 0:20 0:26 0:05 0:74 0:55 0:36 0:04 0:13
Kurt 6:60 3:20 4:71 3:27 5:01 3:50 3:76 5:11 6:38 3:48 3:18 3:16
SR 0:52 0:04 0:36 0:19 0:05 0:62 0:36 0:19 0:38 0:16 0:07 0:44
13

AC1 0:10 0:11 0:08 0:13 0:03 0:03 0:12 0:22 0:15 0:12 0:08 0:01
F req 0:09 0:12 0:10 0:14 0:07 0:07 0:08 0:10 0:11 0:14 0:06 0:06
Panel B: FX Returns
M ean 4:21 0:15 2:92 2:03 1:26 2:95 1:45 0:13 2:50 1:52 1:14 0:31
Sdev 10:08 8:10 9:21 9:27 10:47 9:44 8:99 9:16 8:63 9:12 9:70 8:97
Skew 0:40 0:18 0:04 0:08 0:16 0:29 0:14 0:87 0:60 0:35 0:01 0:15
Kurt 6:73 3:29 4:71 3:33 5:15 3:51 3:74 5:54 6:58 3:50 3:26 3:16
SR 0:42 0:02 0:32 0:22 0:12 0:31 0:16 0:01 0:29 0:17 0:12 0:03
AC1 0:10 0:09 0:06 0:12 0:01 0:02 0:10 0:23 0:14 0:11 0:05 0:01
F req 0:09 0:12 0:10 0:14 0:07 0:07 0:08 0:10 0:11 0:14 0:06 0:06
Panel C: Transition Matrix
PL 0:91 0:09 0:00 0:00 0:00 0:94 0:06 0:00 0:00 0:00
P2 0:09 0:88 0:03 0:00 0:00 0:05 0:91 0:04 0:00 0:00
P3 0:00 0:03 0:91 0:06 0:00 0:00 0:03 0:90 0:07 0:00
P4 0:00 0:00 0:06 0:87 0:06 0:00 0:00 0:07 0:88 0:06
PS 0:00 0:00 0:00 0:06 0:94 0:00 0:00 0:00 0:05 0:95
0:20 0:19 0:19 0:20 0:21 0:15 0:17 0:21 0:22 0:25
Table 11. Risk Reversal Portfolios

This table presents descriptive statistics of …ve currency portfolios sorted on the 1-year volatility risk premia V RP at time t 1. The long (short)
portfolio PL (PS ) contains the top 20% of all currencies with the highest (lowest) volatility risk premia. DOL is the average of the currency portfolios.
HM L is a long-short strategy that buys PL and sells PS . The table also reports the …rst order autocorrelation coe¢ cient (AC1 ), the annualized Sharpe
ratio (SR), the Sortino ratio (SO), the maximum drawdown (M DD), and the frequency of portfolio switches (F req). Newey and West (1987) standard
errors with Andrews (1991) optimal lag selection are reported in parenthesis. Panel A displays the overall currency excess return, whereas Panel B reports
only the exchange rate component. Returns are expressed in percentage per annum. The strategies are rebalanced monthly from January 1996 to August
2011. Exchange rates are from Datastream whereas implied volatility quotes are proprietary data from JP Morgan.

Panel A: Excess Returns


PL P2 P3 P4 PS H=L PL P2 P3 P4 PS H=L
Developed Developed & Emerging
M ean 5:41 1:68 1:06 1:60 0:11 5:30 4:49 2:16 3:00 0:27 0:89 5:38
Sdev 12:02 8:23 9:41 9:64 8:62 11:40 11:16 9:70 9:01 9:62 7:85 10:60
Skew 0:28 0:72 0:09 0:01 0:43 0:72 0:29 1:11 0:00 0:18 0:53 0:14
Kurt 5:26 5:01 3:84 3:97 2:84 6:58 4:78 7:19 3:43 3:58 3:38 4:43
SR 0:45 0:20 0:11 0:17 0:01 0:46 0:40 0:22 0:33 0:03 0:11 0:51
14

AC1 0:14 0:16 0:13 0:08 0:08 0:07 0:17 0:09 0:12 0:17 0:07 0:08
F req 0:17 0:34 0:50 0:47 0:27 0:27 0:22 0:29 0:42 0:41 0:26 0:26
Panel B: FX Returns
M ean 3:33 1:29 1:26 1:95 1:90 1:42 1:17 0:63 2:93 0:69 0:94 0:22
Sdev 12:02 8:15 9:37 9:53 8:48 11:48 11:12 9:67 8:91 9:54 7:70 10:60
Skew 0:30 0:70 0:10 0:00 0:42 0:75 0:37 1:27 0:03 0:21 0:54 0:21
Kurt 5:40 4:98 3:81 3:98 2:83 6:83 5:10 7:80 3:47 3:56 3:34 4:74
SR 0:28 0:16 0:13 0:20 0:22 0:12 0:10 0:07 0:33 0:07 0:12 0:02
AC1 0:13 0:16 0:12 0:07 0:05 0:08 0:16 0:09 0:11 0:17 0:04 0:08
F req 0:17 0:34 0:50 0:47 0:27 0:27 0:22 0:29 0:42 0:41 0:26 0:26
Panel C: Transition Matrix
PL 0:83 0:11 0:02 0:02 0:02 0:79 0:15 0:02 0:02 0:02
P2 0:09 0:67 0:17 0:05 0:03 0:11 0:72 0:12 0:03 0:01
P3 0:02 0:17 0:51 0:23 0:07 0:02 0:14 0:59 0:20 0:06
P4 0:01 0:07 0:23 0:54 0:15 0:01 0:04 0:20 0:59 0:15
PS 0:01 0:02 0:06 0:17 0:74 0:01 0:02 0:07 0:15 0:76
0:16 0:21 0:21 0:21 0:21 0:15 0:23 0:21 0:20 0:20
Table 12. Volatility Risk Premia Portfolios: Currency Breakdown

The table presents the composition of the volatility risk premia portfolios: the number of times (and the frequency in brackets) a currency enters each
of the …ve currency portfolios. The frequency is computed as ratio between the number of times a currency appears in a given portfolio and the total
number of times (T OT ) the currency is available to an investor. The strategies are rebalanced monthly from January 1996 to August 2011. Exchange
rates are from Datastream whereas implied volatility quotes are proprietary data from JP Morgan.

PL P2 P3 P4 PS T ot PL P2 P3 P4 PS T ot
Developed Developed & Emerging
AU D 89 [0:48] 52 [0:28] 19 [0:10] 11 [0:06] 16 [0:09] 187 [1:00] 93 [0:50] 59 [0:32] 18 [0:10] 17 [0:09] 187 [1:00]
CAD 32 [0:17] 56 [0:30] 37 [0:20] 31 [0:17] 31 [0:17] 187 [1:00] 39 [0:21] 59 [0:32] 41 [0:22] 37 [0:20] 11 [0:06] 187 [1:00]
CHF 38 [0:20] 60 [0:32] 65 [0:35] 15 [0:08] 9 [0:05] 187 [1:00] 40 [0:21] 77 [0:41] 48 [0:26] 13 [0:07] 9 [0:05] 187 [1:00]
DKK 10 [0:05] 31 [0:17] 84 [0:45] 62 [0:33] 187 [1:00] 25 [0:13] 51 [0:27] 87 [0:47] 24 [0:13] 187 [1:00]
EU R 5 [0:03] 12 [0:07] 36 [0:22] 68 [0:42] 42 [0:26] 163 [1:00] 5 [0:03] 24 [0:15] 60 [0:37] 65 [0:40] 9 [0:06] 163 [1:00]
GBP 14 [0:07] 26 [0:14] 53 [0:28] 41 [0:22] 53 [0:28] 187 [1:00] 15 [0:08] 40 [0:21] 59 [0:32] 30 [0:16] 43 [0:23] 187 [1:00]
JP Y 71 [0:38] 30 [0:16] 24 [0:13] 15 [0:08] 44 [0:24] 184 [1:00] 76 [0:41] 34 [0:18] 22 [0:12] 21 [0:11] 31 [0:17] 184 [1:00]
N OK 21 [0:11] 56 [0:30] 38 [0:2] 29 [0:16] 41 [0:22] 185 [1:00] 25 [0:13] 65 [0:35] 39 [0:21] 21 [0:11] 35 [0:19] 185 [1:00]
N ZD 49 [0:26] 44 [0:24] 28 [0:15] 32 [0:17] 34 [0:18] 187 [1:00] 49 [0:26] 52 [0:28] 39 [0:21] 38 [0:20] 9 [0:05] 187 [1:00]
15

SEK 27 [0:15] 28 [0:15] 43 [0:23] 47 [0:25] 40 [0:22] 185 [1:00] 25 [0:13] 46 [0:25] 44 [0:24] 39 [0:21] 31 [0:17] 185 [1:00]
BRL 5 [0:07] 10 [0:15] 5 [0:07] 5 [0:07] 42 [0:63] 67 [1:00]
CZK 11 [0:16] 13 [0:19] 23 [0:34] 17 [0:25] 3 [0:04] 67 [1:00]
HU F 10 [0:18] 4 [0:07] 3 [0:05] 18 [0:33] 20 [0:36] 55 [1:00]
KRW 28 [0:42] 5 [0:07] 10 [0:15] 12 [0:18] 12 [0:18] 67 [1:00]
M XN 3 [0:04] 7 [0:10] 13 [0:19] 44 [0:66] 67 [1:00]
P LN 31 [0:46] 17 [0:25] 8 [0:12] 5 [0:07] 6 [0:09] 67 [1:00]
SGD 2 [0:03] 16 [0:24] 22 [0:33] 19 [0:28] 8 [0:12] 67 [1:00]
T RY 3 [0:04] 6 [0:09] 5 [0:07] 53 [0:79] 67 [1:00]
TWD 3 [0:02] 12 [0:09] 15 [0:12] 27 [0:21] 70 [0:55] 127 [1:00]
ZAR 8 [0:09] 7 [0:08] 7 [0:08] 18 [0:21] 46 [0:53] 86 [1:00]
Table 13. Carry Trade Portfolios: Currency Breakdown

The table presents the composition of the carry trade portfolios: the number of times (and the frequency in brackets) a currency enters each of the
…ve currency portfolios. The frequency is computed as ratio between the number of times a currency appears in a given portfolio and the total number of
times (T OT ) the currency is available to an investor. The strategies are rebalanced monthly from January 1996 to August 2011. Exchange rates are from
Datastream whereas implied volatility quotes are proprietary data from JP Morgan.

PL P2 P3 P4 PS T ot PL P2 P3 P4 PS T ot
Developed Developed & Emerging
AU D 105 [0:56] 75 [0:40] 5 [0:03] 1 [0:01] 1 [0:01] 187 [1:00] 32 [0:17] 145 [0:78] 8 [0:04] 1 [0:01] 1 [0:01] 187 [1:00]
CAD 3 [0:02] 56 [0:30] 59 [0:32] 68 [0:36] 1 [0:01] 187 [1:00] 3 [0:02] 39 [0:21] 65 [0:35] 78 [0:42] 2 [0:01] 187 [1:00]
CHF 1 [0:01] 2 [0:01] 5 [0:03] 179 [0:96] 187 [1:00] 1 [0:01] 2 [0:01] 32 [0:17] 152 [0:81] 187 [1:00]
DKK 1 [0:01] 30 [0:16] 99 [0:53] 56 [0:30] 1 [0:01] 187 [1:00] 1 [0:01] 15 [0:08] 103 [0:55] 64 [0:34] 4 [0:02] 187 [1:00]
EU R 1 [0:01] 58 [0:36] 100 [0:61] 4 [0:02] 163 [1:00] 1 [0:01] 1 [0:01] 49 [0:30] 108 [0:66] 4 [0:02] 163 [1:00]
GBP 22 [0:12] 106 [0:57] 44 [0:24] 14 [0:07] 1 [0:01] 187 [1:00] 22 [0:12] 111 [0:59] 17 [0:09] 35 [0:19] 2 [0:01] 187 [1:00]
JP Y 1 [0:01] 6 [0:03] 177 [0:96] 184 [1:00] 1 [0:01] 2 [0:01] 181 [0:98] 184 [1:00]
N OK 51 [0:27] 55 [0:30] 31 [0:17] 48 [0:26] 185 [1:00] 49 [0:26] 17 [0:09] 70 [0:38] 47 [0:25] 2 [0:01] 185 [1:00]
N ZD 160 [0:86] 14 [0:07] 11 [0:06] 2 [0:01] 187 [1:00] 106 [0:57] 65 [0:35] 14 [0:07] 2 [0:01] 187 [1:00]
16

SEK 2 [0:01] 38 [0:20] 64 [0:34] 73 [0:39] 8 [0:04] 185 [1:00] 2 [0:01] 35 [0:19] 63 [0:34] 56 [0:30] 29 [0:16] 185 [1:00]
BRL 65 [0:97] 1 [0:01] 1 [0:01] 67 [1:00]
CZK 1 [0:01] 42 [0:63] 20 [0:30] 4 [0:06] 67 [1:00]
HU F 24 [0:44] 31 [0:56] 55 [1:00]
KRW 2 [0:03] 42 [0:63] 9 [0:13] 14 [0:21] 67 [1:00]
M XN 10 [0:15] 56 [0:84] 1 [0:01] 67 [1:00]
P LN 35 [0:52] 31 [0:46] 1 [0:01] 67 [1:00]
SGD 11 [0:16] 24 [0:36] 32 [0:48] 67 [1:00]
T RY 67 [1:00] 67 [1:00]
TWD 3 [0:02] 10 [0:08] 8 [0:06] 28 [0:22] 78 [0:61] 127 [1:00]
ZAR 82 [0:95] 4 [0:05] 86 [1:00]
Table 14. Momentum Portfolios: Currency Breakdown

The table presents the composition of themomentum portfolios: the number of times (and the frequency in brackets) a currency enters each of the
…ve currency portfolios. The frequency is computed as ratio between the number of times a currency appears in a given portfolio and the total number of
times (T OT ) the currency is available to an investor. The strategies are rebalanced monthly from January 1996 to August 2011. Exchange rates are from
Datastream whereas implied volatility quotes are proprietary data from JP Morgan.

PL P2 P3 P4 PS T ot PL P2 P3 P4 PS T ot
Developed Developed & Emerging
AU D 46 [0:25] 51 [0:27] 28 [0:15] 19 [0:10] 43 [0:23] 187 [1:00] 40 [0:21] 61 [0:33] 31 [0:17] 17 [0:09] 38 [0:20] 187 [1:00]
CAD 55 [0:29] 23 [0:12] 34 [0:18] 35 [0:19] 40 [0:21] 187 [1:00] 49 [0:26] 30 [0:16] 39 [0:21] 34 [0:18] 35 [0:19] 187 [1:00]
CHF 35 [0:19] 32 [0:17] 37 [0:20] 46 [0:25] 37 [0:20] 187 [1:00] 35 [0:19] 36 [0:19] 40 [0:21] 40 [0:21] 36 [0:19] 187 [1:00]
DKK 12 [0:06] 44 [0:24] 59 [0:32] 56 [0:30] 16 [0:09] 187 [1:00] 14 [0:07] 48 [0:26] 56 [0:30] 52 [0:28] 17 [0:09] 187 [1:00]
EU R 12 [0:07] 46 [0:28] 49 [0:30] 35 [0:21] 21 [0:13] 163 [1:00] 9 [0:06] 58 [0:36] 44 [0:27] 39 [0:24] 13 [0:08] 163 [1:00]
GBP 26 [0:14] 44 [0:24] 42 [0:22] 37 [0:20] 38 [0:20] 187 [1:00] 24 [0:13] 47 [0:25] 44 [0:24] 43 [0:23] 29 [0:16] 187 [1:00]
JP Y 42 [0:23] 13 [0:07] 26 [0:14] 41 [0:22] 62 [0:34] 184 [1:00] 38 [0:21] 20 [0:11] 31 [0:17] 39 [0:21] 56 [0:30] 184 [1:00]
N OK 31 [0:17] 44 [0:24] 45 [0:24] 30 [0:16] 35 [0:19] 185 [1:00] 26 [0:14] 53 [0:28] 37 [0:20] 39 [0:21] 30 [0:16] 185 [1:00]
N ZD 55 [0:29] 39 [0:21] 20 [0:11] 26 [0:14] 47 [0:25] 187 [1:00] 48 [0:26] 48 [0:26] 22 [0:12] 26 [0:14] 43 [0:23] 187 [1:00]
17

SEK 32 [0:17] 38 [0:20] 34 [0:18] 48 [0:26] 33 [0:18] 185 [1:00] 25 [0:13] 41 [0:22] 46 [0:25] 40 [0:22] 33 [0:18] 185 [1:00]
BRL 24 [0:36] 10 [0:15] 12 [0:18] 12 [0:18] 9 [0:13] 67 [1:00]
CZK 20 [0:30] 17 [0:25] 11 [0:16] 11 [0:16] 8 [0:12] 67 [1:00]
HU F 15 [0:27] 8 [0:15] 10 [0:18] 6 [0:11] 16 [0:29] 55 [1:00]
KRW 9 [0:13] 10 [0:15] 17 [0:25] 15 [0:22] 16 [0:24] 67 [1:00]
M XN 10 [0:15] 10 [0:15] 11 [0:16] 15 [0:22] 21 [0:31] 67 [1:00]
P LN 18 [0:27] 15 [0:22] 10 [0:15] 14 [0:21] 10 [0:15] 67 [1:00]
SGD 7 [0:10] 16 [0:24] 22 [0:33] 13 [0:19] 9 [0:13] 67 [1:00]
T RY 16 [0:24] 6 [0:09] 16 [0:24] 10 [0:15] 19 [0:28] 67 [1:00]
TWD 22 [0:17] 18 [0:14] 17 [0:13] 25 [0:20] 45 [0:35] 127 [1:00]
ZAR 19 [0:22] 16 [0:19] 11 [0:13] 17 [0:20] 23 [0:27] 86 [1:00]
Table 15. Value Portfolios: Currency Breakdown

The table presents the composition of the value portfolios: the number of times (and the frequency in brackets) a currency enters each of the …ve
currency portfolios. The frequency is computed as ratio between the number of times a currency appears in a given portfolio and the total number of
times (T OT ) the currency is available to an investor. The strategies are rebalanced monthly from January 1996 to August 2011. Exchange rates are from
Datastream whereas implied volatility quotes are proprietary data from JP Morgan.

PL P2 P3 P4 PS T ot PL P2 P3 P4 PS T ot
Developed Developed & Emerging
AU D 77 [0:41] 57 [0:30] 37 [0:20] 16 [0:09] 187 [1:00] 16 [0:09] 96 [0:51] 23 [0:12] 36 [0:19] 16 [0:09] 187 [1:00]
CAD 81 [0:43] 105 [0:56] 1 [0:01] 187 [1:00] 50 [0:27] 68 [0:36] 11 [0:06] 58 [0:31] 187 [1:00]
CHF 35 [0:19] 152 [0:81] 187 [1:00] 4 [0:02] 183 [0:98] 187 [1:00]
DKK 3 [0:02] 108 [0:58] 76 [0:41] 187 [1:00] 1 [0:01] 95 [0:51] 91 [0:49] 187 [1:00]
EU R 11 [0:07] 130 [0:8] 22 [0:13] 163 [1:00] 77 [0:47] 29 [0:18] 57 [0:35] 163 [1:00]
GBP 29 [0:16] 21 [0:11] 137 [0:73] 187 [1:00] 9 [0:05] 140 [0:75] 38 [0:20] 187 [1:00]
JP Y 17 [0:09] 6 [0:03] 31 [0:17] 53 [0:29] 77 [0:42] 184 [1:00] 25 [0:14] 61 [0:33] 98 [0:53] 184 [1:00]
N OK 2 [0:01] 116 [0:62] 67 [0:36] 185 [1:00] 2 [0:01] 97 [0:52] 86 [0:46] 185 [1:00]
N ZD 131 [0:70] 55 [0:29] 1 [0:01] 187 [1:00] 67 [0:36] 50 [0:27] 57 [0:30] 13 [0:07] 187 [1:00]
18

SEK 140 [0:75] 45 [0:24] 185 [1:00] 105 [0:56] 48 [0:26] 32 [0:17] 185 [1:00]
BRL 1 [0:01] 26 [0:39] 40 [0:60] 67 [1:00]
CZK 3 [0:04] 41 [0:61] 23 [0:34] 67 [1:00]
HU F 12 [0:22] 42 [0:76] 1 [0:02] 55 [1:00]
KRW 4 [0:06] 38 [0:57] 25 [0:37] 67 [1:00]
M XN 49 [0:73] 16 [0:24] 2 [0:03] 67 [1:00]
P LN 20 [0:30] 45 [0:67] 2 [0:03] 67 [1:00]
SGD 26 [0:39] 41 [0:61] 67 [1:00]
T RY 54 [0:81] 13 [0:19] 67 [1:00]
TWD 127 [1:00] 127 [1:00]
ZAR 65 [0:76] 21 [0:24] 86 [1:00]
Table 16. Risk Reversal Portfolios: Currency Breakdown

The table presents the composition of the risk reversal portfolios: the number of times (and the frequency in brackets) a currency enters each of the
…ve currency portfolios. The frequency is computed as ratio between the number of times a currency appears in a given portfolio and the total number of
times (T OT ) the currency is available to an investor. The strategies are rebalanced monthly from January 1996 to August 2011. Exchange rates are from
Datastream whereas implied volatility quotes are proprietary data from JP Morgan.

PL P2 P3 P4 PS T ot PL P2 P3 P4 PS T ot
Developed Developed & Emerging
AU D 142 [0:76] 32 [0:17] 7 [0:04] 3 [0:02] 3 [0:02] 187 [1:00] 64 [0:34] 95 [0:51] 38 [0:20] 3 [0:02] 3 [0:02] 203 [1:09]
CAD 25 [0:13] 83 [0:44] 17 [0:09] 29 [0:16] 27 [0:14] 181 [0:97] 19 [0:10] 72 [0:39] 25 [0:13] 32 [0:17] 49 [0:26] 197 [1:05]
CHF 2 [0:01] 11 [0:06] 54 [0:29] 116 [0:62] 183 [0:98] 4 [0:02] 10 [0:05] 66 [0:35] 117 [0:63] 197 [1:05]
DKK 3 [0:02] 23 [0:12] 56 [0:30] 73 [0:39] 28 [0:15] 183 [0:98] 2 [0:01] 13 [0:07] 49 [0:26] 100 [0:53] 35 [0:19] 199 [1:06]
EU R 16 [0:10] 70 [0:43] 56 [0:34] 19 [0:12] 161 [1:00] 4 [0:02] 60 [0:37] 85 [0:52] 28 [0:17] 177 [1:09]
GBP 8 [0:04] 115 [0:61] 36 [0:19] 16 [0:09] 9 [0:05] 184 [0:98] 6 [0:03] 69 [0:37] 81 [0:43] 26 [0:14] 18 [0:10] 200 [1:07]
JP Y 11 [0:06] 16 [0:09] 19 [0:10] 5 [0:03] 133 [0:72] 184 [1:00] 9 [0:05] 19 [0:10] 18 [0:10] 5 [0:03] 150 [0:81] 201 [1:09]
N OK 19 [0:10] 64 [0:34] 86 [0:46] 12 [0:06] 181 [0:97] 9 [0:05] 57 [0:31] 115 [0:62] 16 [0:09] 197 [1:06]
N ZD 138 [0:74] 42 [0:22] 3 [0:02] 1 [0:01] 184 [0:98] 65 [0:35] 95 [0:51] 39 [0:21] 1 [0:01] 200 [1:07]
19

SEK 5 [0:03] 25 [0:13] 89 [0:48] 48 [0:26] 15 [0:08] 182 [0:98] 5 [0:03] 12 [0:06] 82 [0:44] 91 [0:49] 9 [0:05] 199 [1:07]
BRL 71 [1:06] 9 [0:13] 80 [1:19]
CZK 4 [0:06] 71 [1:06] 8 [0:12] 83 [1:24]
HU F 32 [0:58] 40 [0:73] 72 [1:31]
KRW 46 [0:69] 10 [0:15] 7 [0:10] 9 [0:13] 12 [0:18] 84 [1:25]
M XN 22 [0:33] 51 [0:76] 10 [0:15] 83 [1:24]
P LN 8 [0:12] 64 [0:96] 11 [0:16] 83 [1:24]
SGD 23 [0:34] 24 [0:36] 35 [0:52] 82 [1:22]
T RY 45 [0:67] 37 [0:55] 1 [0:01] 83 [1:24]
TWD 23 [0:18] 7 [0:06] 8 [0:06] 5 [0:04] 88 [0:69] 131 [1:03]
ZAR 84 [0:98] 18 [0:21] 102 [1:19]
Table 17. -Sorted Portfolios: Principal Component of Volatility Risk Premia

This table presents descriptive statistics of -sorted currency portfolios. Each is obtained by regressing
individual currency excess returns on the …rst principal component of volatility risk premia using a 36-month
moving window. The long (short) portfolio PL (PS ) contains the top 20% of all currencies with the lowest
(highest) . H=L denotes a long-short strategy that buys PL and sells PS . The table also reports the …rst order
autocorrelation coe¢ cient (AC1 ), the annualized Sharpe ratio (SR), and the frequency of portfolio switches
(F req). Panel A displays the overall excess return, whereas Panel B reports the exchange rate component only.
Panel C presents the pre- and post-formation s, and the pre- and post-formation interest rate di¤erential (if)
relative to the US dollar. Standard deviations are reported in brackets whereas standard errors are reported
in parentheses. Returns are expressed in percentage per annum. The strategies are rebalanced monthly from
January 1996 to August 2001. Exchange rates are from Datastream whereas implied volatility quotes are
proprietary data from JP Morgan.

Panel A: Excess Returns


PL P2 P3 P4 PS H=L PL P2 P3 P4 PS H=L
Developed Developed & Emerging
M ean 5:76 2:07 2:72 1:45 7:15 1:40 3:69 2:62 3:13 2:48 5:70 2:00
Sdev 9:51 10:45 8:84 10:66 11:69 10:80 8:61 9:97 10:13 9:37 11:19 10:65
Skew 0:24 0:03 0:51 0:00 0:38 0:79 0:08 0:35 0:20 0:49 0:49 0:96
Kurt 3:03 4:58 5:33 4:17 5:20 6:94 2:43 4:78 4:22 5:58 4:65 6:46
SR 0:61 0:20 0:31 0:14 0:61 0:13 0:43 0:26 0:31 0:26 0:51 0:19
SO 1:15 0:30 0:42 0:20 0:86 0:22 0:80 0:43 0:47 0:38 0:71 0:36
M DD 0:17 0:26 0:31 0:33 0:26 0:36 0:24 0:23 0:31 0:29 0:26 0:33
AC1 0:01 0:01 0:21 0:11 0:08 0:04 0:08 0:06 0:15 0:14 0:08 0:01
F req 0:15 0:25 0:31 0:29 0:11 0:11 0:14 0:17 0:22 0:23 0:11 0:11
Panel B: FX Returns
M ean 6:52 2:26 2:41 0:67 5:02 1:50 4:59 2:56 2:49 1:15 3:52 1:06
Sdev 9:43 10:40 8:79 10:53 11:67 10:88 8:52 9:90 10:06 9:25 11:17 10:75
Skew 0:28 0:02 0:55 0:04 0:40 0:86 0:10 0:34 0:22 0:58 0:61 1:14
Kurt 3:08 4:56 5:48 4:11 5:25 7:16 2:40 4:85 4:25 5:48 4:84 7:02
SR 0:69 0:22 0:27 0:06 0:43 0:14 0:54 0:26 0:25 0:12 0:32 0:10
SO 1:36 0:33 0:38 0:09 0:60 0:24 1:04 0:42 0:37 0:17 0:42 0:20
M DD 0:15 0:25 0:32 0:33 0:28 0:32 0:20 0:21 0:32 0:30 0:32 0:23
AC1 0:00 0:01 0:22 0:10 0:07 0:05 0:07 0:06 0:14 0:13 0:08 0:00
F req 0:15 0:25 0:31 0:29 0:11 0:11 0:14 0:17 0:22 0:23 0:11 0:11
Panel C: Portfolio Formation
pre-if 0:77 0:18 0:31 0:78 2:13 0:89 0:06 0:64 1:33 2:17
post-if 0:69 0:24 0:38 0:84 2:13 0:94 0:10 0:68 1:34 2:18
pre- 0:11 0:05 0:05 0:11 0:21 0:11 0:05 0:05 0:11 0:21
[0:12] [0:13] [0:12] [0:11] [0:14] [0:12] [0:13] [0:12] [0:11] [0:14]
post- 0:10 0:04 0:04 0:02 0:07 0:07 0:05 0:02 0:03 0:02
(0:04) (0:02) (0:03) (0:04) (0:02) (0:02) (0:03) (0:02) (0:02) (0:02)

20
Table 18. -Sorted Portfolios: Equity Volatility Risk Premium

This table presents descriptive statistics of -sorted currency portfolios. Each is obtained by regressing
individual currency excess returns on the US equity volatility risk premium using a 36-month moving window.
The volatility risk premium is de…ned as the 1-month realized volatility on the S&P500 minus the VIX index.
The long (short) portfolio PL (PS ) contains the top 20% of all currencies with the lowest (highest) . H=L
denotes a long-short strategy that buys PL and sells PS . The table also reports the …rst order autocorrelation
coe¢ cient (AC1 ), the annualized Sharpe ratio (SR), and the frequency of portfolio switches (F req). Panel
A displays the overall excess return, whereas Panel B reports the exchange rate component only. Panel
C presents the pre- and post-formation s, and the pre- and post-formation interest rate di¤erential (if)
relative to the US dollar. Standard deviations are reported in brackets whereas standard errors are reported
in parentheses. Returns are expressed in percentage per annum. The strategies are rebalanced monthly from
January 1996 to August 2001. Data are from Datastream.

Panel A: Excess Returns


PL P2 P3 P4 PS H=L PL P2 P3 P4 PS H=L
Developed Developed & Emerging
M ean 6:22 3:65 2:43 2:33 3:50 2:72 7:04 2:46 3:52 1:98 3:29 3:76
Sdev 11:04 10:24 10:19 10:47 8:73 10:07 10:85 10:37 9:67 10:37 7:59 9:96
Skew 0:58 0:17 0:02 0:06 0:30 1:10 0:72 0:28 0:04 0:43 0:19 1:08
Kurt 4:98 4:41 4:21 4:56 3:74 7:83 6:03 4:05 4:31 4:69 2:62 10:41
SR 0:56 0:36 0:24 0:22 0:40 0:27 0:65 0:24 0:36 0:19 0:43 0:38
SO 0:78 0:56 0:38 0:33 0:73 0:33 0:88 0:36 0:56 0:32 0:71 0:47
M DD 0:27 0:28 0:32 0:28 0:20 0:32 0:23 0:30 0:30 0:28 0:20 0:25
AC1 0:11 0:12 0:24 0:06 0:05 0:03 0:14 0:15 0:21 0:04 0:00 0:05
F req 0:12 0:25 0:29 0:30 0:16 0:16 0:16 0:25 0:32 0:33 0:17 0:17
Panel B: FX Returns
M ean 4:55 3:15 2:18 2:43 3:68 0:87 4:74 1:28 3:12 2:16 3:76 0:98
Sdev 10:97 10:22 10:04 10:42 8:76 10:18 10:72 10:33 9:48 10:30 7:62 10:03
Skew 0:61 0:21 0:00 0:06 0:32 1:17 0:80 0:35 0:08 0:43 0:19 1:23
Kurt 5:07 4:57 4:14 4:55 3:84 8:21 6:37 4:17 4:20 4:77 2:68 11:27
SR 0:41 0:31 0:22 0:23 0:42 0:09 0:44 0:12 0:33 0:21 0:49 0:10
SO 0:57 0:47 0:34 0:34 0:75 0:10 0:59 0:18 0:50 0:35 0:80 0:12
M DD 0:29 0:29 0:32 0:27 0:21 0:36 0:24 0:34 0:28 0:27 0:21 0:30
AC1 0:10 0:12 0:23 0:06 0:05 0:04 0:12 0:15 0:20 0:04 0:00 0:05
F req 0:12 0:25 0:29 0:30 0:16 0:16 0:16 0:25 0:32 0:33 0:17 0:17
Panel C: Portfolio Formation
pre-if 1:67 0:50 0:25 0:10 0:18 2:31 1:17 0:40 0:18 0:47
post-if 1:70 0:54 0:24 0:15 0:12 2:33 1:21 0:38 0:26 0:41
pre- 0:23 0:14 0:08 0:02 0:07 0:23 0:14 0:08 0:02 0:07
[0:15] [0:12] [0:12] [0:10] [0:11] [0:15] [0:12] [0:12] [0:10] [0:11]
post- 0:04 0:03 0:00 0:09 0:02 0:04 0:03 0:00 0:09 0:02
(0:03) (0:02) (0:02) (0:03) (0:06) (0:03) (0:02) (0:02) (0:03) (0:06)

21
Table 19. -Sorted Portfolios: VRP Strategy

This table presents descriptive statistics of -sorted currency portfolios. Each is obtained by regressing
individual currency excess returns on the VRP strategy using a 36-month moving window. The long (short)
portfolio PL (PS ) contains the top 20% of all currencies with the highest (lowest) . H=L denotes a long-short
strategy that buys PL and sells PS . The table also reports the …rst order autocorrelation coe¢ cient (AC1 ),
the annualized Sharpe ratio (SR), and the frequency of portfolio switches (F req). Panel A displays the overall
excess return, whereas Panel B reports the exchange rate component only. Panel C presents the pre- and
post-formation s, and the pre- and post-formation interest rate di¤erential (if) relative to the US dollar.
Standard deviations are reported in brackets whereas standard errors are reported in parentheses. Returns
are expressed in percentage per annum. The strategies are rebalanced monthly from January 1996 to August
2001. Exchange rates are from Datastream whereas implied volatility quotes are proprietary data from JP
Morgan.

Panel A: Excess Returns


PL P2 P3 P4 PS H=L PL P2 P3 P4 PS H=L
Developed Developed & Emerging
M ean 6:73 3:93 2:39 1:57 3:79 2:95 5:94 2:40 4:11 2:51 2:39 3:55
Sdev 9:75 9:51 9:53 10:40 11:89 11:22 9:92 9:00 9:30 11:04 10:44 10:76
Skew 0:13 0:01 0:08 0:19 0:28 0:32 0:16 0:21 0:16 0:18 0:66 0:44
Kurt 3:47 5:90 4:16 4:04 5:08 5:88 3:30 4:29 3:62 3:99 6:54 8:21
SR 0:69 0:41 0:25 0:15 0:32 0:26 0:60 0:27 0:44 0:23 0:23 0:33
SO 1:22 0:61 0:39 0:22 0:46 0:42 1:11 0:39 0:76 0:34 0:31 0:49
M DD 0:23 0:21 0:28 0:28 0:32 0:36 0:23 0:21 0:25 0:32 0:28 0:27
AC1 0:09 0:02 0:11 0:10 0:12 0:12 0:08 0:04 0:09 0:12 0:13 0:06
F req 0:09 0:16 0:18 0:21 0:09 0:09 0:06 0:11 0:16 0:17 0:10 0:10
Panel B: FX Returns
M ean 6:38 3:46 1:91 1:32 3:33 3:05 5:71 2:27 3:65 1:38 1:11 4:60
Sdev 9:66 9:48 9:43 10:30 11:83 11:25 9:80 8:96 9:26 10:91 10:31 10:75
Skew 0:09 0:00 0:05 0:21 0:36 0:47 0:13 0:23 0:13 0:20 0:83 0:68
Kurt 3:56 5:84 4:13 4:15 5:27 6:41 3:36 4:17 3:64 4:14 7:08 9:10
SR 0:66 0:36 0:20 0:13 0:28 0:27 0:58 0:25 0:39 0:13 0:11 0:43
SO 1:12 0:54 0:32 0:19 0:39 0:44 1:05 0:37 0:66 0:19 0:14 0:65
M DD 0:23 0:22 0:29 0:28 0:34 0:32 0:23 0:22 0:26 0:34 0:32 0:21
AC1 0:07 0:02 0:11 0:08 0:12 0:12 0:06 0:04 0:10 0:11 0:12 0:05
F req 0:09 0:16 0:18 0:21 0:09 0:09 0:06 0:11 0:16 0:17 0:10 0:10
Panel C: Portfolio Formation
pre-if 0:35 0:47 0:48 0:24 0:46 0:22 0:13 0:46 1:13 1:27
post-if 0:39 0:48 0:48 0:24 0:48 0:26 0:16 0:44 1:13 1:28
pre- 0:26 0:07 0:24 0:33 0:50 0:51 0:23 0:07 0:05 0:29
[0:33] [0:27] [0:24] [0:24] [0:29] [0:22] [0:17] [0:19] [0:23] [0:34]
post- 0:31 0:11 0:10 0:06 0:17 0:47 0:24 0:07 0:04 0:16
(0:1) (0:06) (0:05) (0:06) (0:07) (0:06) (0:05) (0:06) (0:06) (0:08)

22
Table 20. Double-Sorted Currency Strategies

This table presents descriptive statistics of long/short currency strategies formed by double-sorting currencies into 4 groups using time t 1 information.
Currencies are …rst sorted into 2 groups according to the 3-month exchange rate returns (or volatility risk premia) and then re-sorted using the interest rate
di¤erentials relative to the US dollar. M OM (V RP ) is the high-minus-low currency strategy on the 3-month exchange rate returns (the 1-year expected
volatility premia) whereas F X is the high-minus-low currency strategy on the interest rate di¤erentials relative to the US dollar. The table also reports
the …rst order autocorrelation coe¢ cient (AC1 ), the annualized Sharpe ratio (SR), the Sortino ratio (SO), the maximum drawdown (M DD), and the
frequency of portfolio switches for the long (F reqL ) and the short (F reqS ) position. Newey and West (1987) standard errors with Andrews (1991) optimal
lag selection are reported in parenthesis. Panel A displays the overall currency excess return whereas Panel B reports only the exchange rate component.
Returns are expressed in percentage per annum. The strategies are rebalanced monthly from January 1996 to August 2011. Exchange rates are from
Datastream whereas implied volatility quotes are proprietary data from JP Morgan.

Panel A:Excess Returns


=) =) =) =) =) =)
M OM FX V RP FX V RP M OM M OM FX V RP FX V RP M OM
Developed Developed & Emerging
M ean 1:43 3:28 2:38 3:34 2:02 1:64 1:03 3:33 1:08 4:27 0:84 2:12
Sdev 6:42 5:51 4:73 5:68 4:80 5:65 5:73 5:08 4:76 5:67 4:80 5:03
23

Skew 0:09 0:59 0:33 0:69 0:03 0:11 0:37 0:84 0:03 1:00 0:20 0:10
Kurt 4:54 5:09 3:42 4:15 3:29 3:66 3:87 4:17 3:78 4:63 3:79 4:34
SR 0:22 0:60 0:50 0:59 0:42 0:29 0:18 0:66 0:23 0:75 0:18 0:42
SO 0:33 0:77 0:77 0:78 0:70 0:50 0:25 0:84 0:37 0:99 0:30 0:64
M DD 0:16 0:15 0:13 0:18 0:14 0:11 0:16 0:10 0:15 0:17 0:15 0:09
AC1 0:04 0:05 0:07 0:03 0:05 0:05 0:07 0:06 0:02 0:14 0:03 0:01
F reqL 0:36 0:36 0:27 0:27 0:47 0:47 0:38 0:38 0:27 0:27 0:43 0:43
F reqS 0:38 0:38 0:31 0:31 0:47 0:47 0:38 0:38 0:29 0:29 0:42 0:42

Panel B: FX Returns
M ean 0:22 0:32 1:97 0:38 2:08 1:19 0:17 0:57 1:52 0:32 1:54 1:57
Sdev 6:42 5:52 4:74 5:71 4:83 5:65 5:67 5:11 4:81 5:73 4:85 5:01
Skew 0:18 0:58 0:40 0:72 0:08 0:17 0:31 0:92 0:01 1:10 0:19 0:09
Kurt 4:84 5:16 3:42 4:24 3:33 3:95 3:92 4:33 3:90 4:98 3:95 4:64
SR 0:03 0:06 0:42 0:07 0:43 0:21 0:03 0:11 0:32 0:06 0:32 0:31
SO 0:05 0:07 0:61 0:09 0:71 0:35 0:04 0:14 0:51 0:07 0:55 0:47
M DD 0:25 0:20 0:15 0:21 0:14 0:14 0:23 0:19 0:15 0:20 0:15 0:11
AC1 0:03 0:04 0:07 0:04 0:05 0:05 0:05 0:04 0:01 0:16 0:03 0:02
F reqL 0:36 0:36 0:27 0:27 0:56 0:56 0:38 0:38 0:27 0:27 0:43 0:43
F reqS 0:38 0:38 0:31 0:31 0:58 0:58 0:38 0:38 0:29 0:29 0:42 0:42
Table 21. Asset Pricing Tests: Illiquidity Factors
This table reports asset pricing results. The linear factor model includes the dollar (DOL) factor and innovations to global average precentage bid-ask
spreads in the spot market, denoted as BASF X (Panel A), and the option market, denoted as BASIV (Panel B ). BASF X is constructed by averaging over
a month the daily average bid-ask spread of the spot exchange rate. BASIV is constructed by averaging over a month the daily average bid-ask spread
of the 1-year at-the-money (ATM) implied volatility. Innovations are computed as the residual to a …rst-order autoregressive process. The test assets
are currency excess returns to …ve portfolios sorted on the 1-year volatility risk premia (V RP ) available at time t 1. Factor Prices reports GMM and
Fama-MacBeth (FMB) estimates of the factor loadings b, the market price of risk . The 2 and the Hansen-Jagannathan distance are test statistics for
the null hypothesis that all pricing errors are jointly zero. Factor Betas reports least-squares estimates of time series regressions. The 2 ( ) test statistic
tests the null that all intercepts are jointly zero. Newey and West (1987) with Andrews (1991) optimal lag selection are reported in parenthesis. sh denotes
Shanken (1992) standard errors. The p-values are reported in brackets. Returns are annualized. The portfolios are rebalanced monthly from January 1996
to August 2011. Exchange rates are from Datastream whereas implied volatility quotes are proprietary data from JP Morgan.

Panel A: Illiquidity in the Spot Market


Factor Prices
bDOL bBASF X DOL BASF X R2 RM SE 2
HJ bDOL bBASF X DOL BASF X R2 RM SE 2
HJ
Developed Developed & Emerging
24

GM M1 0:43 38:89 0:02 0:06 0:36 2:54 1:00 0:15 0:16 4:65 0:02 0:06 0:02 1:98 2:07 0:11
(0:45) (53:27) (0:02) (0:04) [0:80] [0:80] (0:4) (10:46) (0:02) (0:11) [0:56] [0:60]
GM M2 0:49 56:89 0:02 0:05 0:29 2:58 0:82 0:28 0:45 0:02 0:03 0:11 2:01 1:87
(0:43) (44:17) (0:02) (0:04) [0:84] (0:39) (9:98) (0:02) (0:11) [0:60]
FMB 0:43 38:68 0:02 0:06 0:36 2:54 1:01 0:16 4:62 0:02 0:06 0:02 1:98 2:07
(0:33) (22:75) (0:02) (0:04) [0:80] (0:32) (9:07) (0:02) (0:11) [0:56]
(sh) 0:32 42:21 0:02 0:07 [0:79] 0:31 10:44 0:02 0:12 [0:57]
Factor Betas
DOL BASF X R2 2
( ) DOL BASF X R2 2
( )
PL 0:03 0:88 0:17 0:62 9:67 0:02 0:96 0:03 0:69 2:95
(0:01) (0:07) (0:32) [0:09] (0:01) (0:04) (0:09) [0:71]
P2 0:00 0:96 0:05 0:70 0:00 0:95 0:01 0:79
(0:01) (0:07) (0:12) (0:01) (0:04) (0:09)
P3 0:01 1:01 0:00 0:71 0:01 0:98 0:03 0:79
(0:01) (0:06) (0:11) (0:01) (0:03) (0:07)
P4 0:01 1:10 0:15 0:78 0:01 1:18 0:02 0:83
(0:01) (0:05) (0:29) (0:01) (0:04) (0:09)
PS 0:02 1:05 0:31 0:78 0:01 0:92 0:11 0:71
(0:01) (0:04) (0:17) (0:01) (0:04) (0:10)
(continued)
Table 21. Asset Pricing Tests: Illiquidity Factors (continued)

Panel B: Illiquity Factor in the Option Market


Factor Prices
bDOL bBASIV DOL BASIV
R2 RM SE 2
HJ bDOL bBAS DOL BASIV
R2 RM SE 2
HJ
IV
Developed Developed & Emerging
GM M1 0:41 8:91 0:02 0:01 0:16 3:42% 4:32 0:16 0:13 8:13 0:02 0:02 0:04 2:00% 1:27 0:11
(0:52) (22:04) (0:02) (0:03) [0:23] [0:22] (0:51) (18:14) (0:02) (0:04) [0:74] [0:61]
GM M2 0:30 8:99 0:02 0:01 0:16 3:43% 4:18 0:20 8:88 0:02 0:01 0:09 2:01% 1:24
(0:51) (21:44) (0:02) (0:03) [0:24] (0:48) (17:89) (0:02) (0:04) [0:74]
FMB 0:41 8:86 0:02 0:01 0:16 3:42% 4:32 0:13 8:09 0:02 0:02 0:04 2:00% 1:27
(0:52) (21:07) (0:02) (0:03) [0:23] (0:36) (16:49) (0:02) (0:04) [0:74]
(sh) (0:49) (23) (0:02) (0:03) [0:21] (0:34) (16:97) (0:02) (0:04) [0:59]
Factor Betas
DOL BASIV
R2 2
( ) DOL BASIV
R2 2
( )
PL 0:03 0:88 0:05 0:62 9:69 0:02 0:96 0:04 0:69 2:92
(0:01) (0:06) (0:54) (0:08) (0:01) (0:05) (0:32) (0:71)
P2 0:00 0:95 0:19 0:71 0:00 0:95 0:06 0:79
25

(0:01) (0:07) (0:48) (0:01) (0:04) (0:26)


P3 0:01 1:02 0:12 0:71 0:01 0:98 0:17 0:79
(0:01) (0:05) (0:57) (0:01) (0:03) (0:22)
P4 0:01 1:10 0:24 0:79 0:01 1:18 0:28 0:83
(0:01) (0:05) (0:43) (0:01) (0:04) (0:26)
PS 0:02 1:05 0:25 0:78 0:01 0:92 0:05 0:71
(0:01) (0:04) (0:37) (0:01) (0:04) (0:21)
Table 22. Principal Component Analysis: Volatility Risk Premia

This table presents principal component analysis of the 1-year volatility risk premia. We apply the EM algorithm proposed by Stock and Watson
(2002) for an unbalanced set of data. Implied volatility quotes are from JP Morgan.

P1 P2 P3 P4 P5 P1 P2 P3 P4 P5
Developed Countries Developed & Emerging Countries
AUD 0:31 0:70 0:11 0:01 0:50 0:12 0:43 0:22 0:30 0:01
CAD 0:21 0:09 0:15 0:15 0:50 0:12 0:04 0:05 0:05 0:08
CHF 0:27 0:07 0:15 0:28 0:05 0:13 0:10 0:00 0:02 0:30
DKK 0:35 0:33 0:04 0:24 0:08 0:19 0:01 0:00 0:15 0:21
EUR 0:35 0:31 0:03 0:29 0:03 0:19 0:02 0:02 0:14 0:21
GBP 0:34 0:27 0:14 0:25 0:29 0:19 0:05 0:03 0:09 0:07
JPY 0:21 0:03 0:89 0:17 0:06 0:10 0:02 0:09 0:27 0:44
NOK 0:38 0:00 0:09 0:39 0:06 0:18 0:19 0:05 0:07 0:22
NZD 0:28 0:46 0:05 0:53 0:57 0:13 0:28 0:01 0:15 0:00
SEK 0:39 0:00 0:35 0:48 0:28 0:19 0:21 0:08 0:14 0:17
26

BRL 0:33 0:04 0:09 0:53 0:29


CZK 0:18 0:22 0:16 0:27 0:10
HUF 0:27 0:05 0:01 0:47 0:24
KRW 0:31 0:33 0:21 0:14 0:18
MXN 0:42 0:26 0:41 0:16 0:15
PLN 0:20 0:28 0:18 0:34 0:23
SGD 0:19 0:18 0:17 0:03 0:17
TRY 0:33 0:41 0:57 0:01 0:24
TWD 0:22 0:36 0:26 0:05 0:31
ZAR 0:18 0:04 0:47 0:02 0:33
Var 0:74 0:87 0:92 0:95 0:97 0:68 0:80 0:86 0:91 0:94
Table 23. Risk Factors: Liquidity and Hedging

This table presents predictive regressions estimates. The dependent variable is the exchange rate return component of the V RP strategy at time t.
This strategy is a long/short portfolio that buys (sells) the top 20% of all currencies with the highest (lowest) 1-year expected volatility premia at time
t 1. The predictors are measured at time t 1, and include the T ED spread, the change in the V IX index, the change in the St.Louis Fed Financial
Stress Index F SI, the net short futures position (HED) of commercial and non-commercial traders on the Australian dollar (AUD) and the Japanese yen
(JPY) vis-a-vis the US dollar (USD), respectively, and the F und F lows constructed as the AUM-weighted net ‡ows into hedge funds (currency and global
macro funds) scaled by the lagged AUM. Newey and West (1987) with Andrews (1991) optimal lag selection are reported in parenthesis. The superscripts
a, b, and c indicate statistical signi…cance at 10%, 5%, and 1%, respectively. Exchange rate returns are annualized. Exchange rates are from Datastream,
implied volatility quotes are from JP Morgan, futures positions are from the US Commodity Futures Trading Commission (CFTC), hedge fund ‡ows are
from Patton and Ramadorai (2013), F SI is from St.Louis Fed’s website, whereas all other data are from Bloomberg.

T ED HED F und T ED Hedging F und


T ED V IX F SI V IX AU DU SD JP Y U SD F lows R2 T ED V IX F SI V IX AU DU SD JP Y U SD F lows R2
D eveloped D eveloped & E m ergin g
0:03 0:15c 0:04 0:00 0:08a 0:01
(0:03) (0:05) (0:03) (0:04)
0:04b 0:01 < :01 0:04a 0:01 < :01
(0:02) (0:01) (0:02) < :01
27

0:04b 0:07 < :01 0:04a 0:08 < :01


(0:02) (0:07) (0:02) (0:06)
0:04b 0:01a 0:02 0:04a < :01c < :01
(0:02) (< :01) (0:02) (< :01)
0:04b 0:02c 0:01 0:04a 0:01c 0:01
(0:02) (< :01) (0:02) (< :01)
0:05b 0:02 < :01 0:04a 0:01 < :01
(0:02) (0:06) (0:02) (0:06)
0:05b 1:50b 0:02 0:05b 1:14 0:01
(0:02) (0:77) (0:02) (0:74)
0:01 0:12b 0:01c 0:89 0:06 0:02 0:05 0:01c 0:81 0:02
(0:04) (0:06) (< :01) (0:72) (0:03) (0:05) (< :01) (0:72)
0:05b 0:00 0:01c 1:34a 0:03 0:04a < :01 0:01c 0:99 0:02
(0:02) (0:01) (< :01) (0:76) (0:02) (< :01) (< :01) (0:72)
0:05b 0:06 0:01c 1:34a 0:03 0:04a 0:07 0:01c 0:97 0:02
(0:02) (0:06) (< :01) (0:73) (0:02) (0:06) (< :01) (0:69)
0:04b 0:01b 0:01c 1:31a 0:05 0:04 < :01c 0:01c 0:99 0:02
(0:02) (< :01) (< :01) (0:73) (0:02) (< :01) (< :01) (0:70)

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