The Cross-Section of Currency Volatility

This paper studies the cross-section of foreign exchange volatility returns. A zero cost trading strategy that is long (short) volatility swaps on G10 currencies that have high (low) historical volatility relative to the implied volatility swap rate produces statistically and economically significant returns. The strategy has a Sharpe Ratio in excess of 1.7 and results are robust to different market conditions and time periods remaining highly profitable after transaction costs; standard risk adjustments do not significantly diminish profitability because the strategy is only weakly correlated with the equity market, the carry trade, and the Fama-French risk factors. Moreover, the historical minus implied volatility (HMI) factor also predicts excess-returns of the underlying currencies. Currencies that have high historical volatility relative to their implied volatility have much higher returns. A market-neutral strategy of the underlying currency returns performs better than the carry trade during the sample period and the two factors are negatively correlated.