Volatility Shocks and Currency Returns

TL;DR

This paper investigates how shocks to currency volatility influence exchange rates, revealing that currencies transmitting more volatility tend to have lower excess returns, with a model linking volatility transmission to country-specific risk.

Contribution

It introduces a novel network-based approach using option-implied volatilities to predict currency returns and links volatility transmission to priced country-specific risk.

Findings

Currencies that transmit more volatility earn lower excess returns

A trading strategy based on volatility transmitters yields high risk-adjusted returns

Volatility transmission forecasts negatively predict future excess returns

Abstract

This paper examines how shocks to currency volatilities predict exchange rates. Using option-implied volatilities, we construct a dynamic, directed network of volatility connections. Currencies that transmit more volatility shocks, which control for common correlation, earn lower excess returns. Buying the weakest and selling the strongest transmitters delivers high risk-adjusted performance, driven by spot exchange rate movements and not explained by standard factors. A general equilibrium model shows that volatility transmission related to idiosyncratic shocks proxies for priced country-specific risk. Assuming a monotonic amplification of domestic idiosyncratic risk, volatility transmission forecasts negatively future excess returns, consistent with the empirical evidence.