Implied volatility term structure and exchange rate predictability

Abstract

This paper provides empirical evidence of the predictive power of the currency implied volatility term structure (IVTS) for the behavior of the exchange rate from both cross-sectional and time series perspectives. Intriguingly, the direction of the prediction is not the same for developed and emerging markets. For developed markets, a high slope means low future returns, while for emerging markets it means high future returns. We analyze predictability from a cross-sectional perspective by building portfolios based on the slope of the term structure, and thus present a new currency trading strategy. For developed (emerging) currencies, we buy (sell) the two currencies with the lowest slopes and sell (buy) the two with the highest slopes. The proposed strategy performs better than common currency strategies – carry trade, risk reversal, and volatility risk premium (VRP) – based on the Sharpe ratio, considering only currency returns, which supports the exchange rate predictability of the IVTS from a cross-sectional perspective.