Board of Governors of the Federal Reserve System

December 2012

Variance Risk Premiums and the Forward Premium Puzzle

Juan M. Londono and Hao Zhou

Abstract:

This paper presents evidence that the foreign exchange appreciation is predictable by the currency variance risk premium at a medium 6-month horizon and by the stock variance risk premium at a short 1-month horizon. Although currency variance risk premiums are highly correlated with each other over longer horizons, their correlations with stock variance risk premiums are quite low. Interestingly the currency variance risk premium has no predictive power for stock returns. We rationalize these findings in a consumption-based asset pricing model with orthogonal local and global economic uncertainties. In our model the market is incomplete in the sense that the global uncertainty is not priced by local stock markets and is therefore a forex-specific phenomenon—the currency uncertainty’s effects on the expected stock return are off-setting between the cash flow channel and the volatility channel.

Keywords: Forward premium puzzle, currency variance risk premium, stock variance risk premium, unspanned currency uncertainty, forex return predictability

PDF: Full Paper