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Volatility Shocks and Currency Returns

Mykola Babiak, Jozef Barunik

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.

Volatility Shocks and Currency 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.

Paper Structure

This paper contains 45 sections, 70 equations, 2 figures, 16 tables.

Table of Contents

  1. Introduction
  2. Shocks to currency volatilities
  3. Currency implied volatilities
  4. A dynamic volatility connectedness
  5. Volatility network definition
  6. The role of heterogeneous persistence and contemporaneous correlations
  7. Numerical implementation
  8. Volatility connectedness measures
  9. Data and currency portfolios
  10. Currency options data
  11. Exchange rate data
  12. Currency excess returns
  13. Volatility shocks and currency returns
  14. Volatility connectedness
  15. Out-of-sample construction of volatility connectedness portfolios
  16. ...and 30 more sections

Figures (2)

  • Figure 1: Volatility connectedness dynamics.
  • Figure 2: Cumulative returns of currency factors.