Options and the Currency Risk Premium

This chapter uses implied volatilities to examine both the existence and form of the currency risk premium. First, I test for “simple efficiency”, under which there is no risk premium and expectations are rational. This involves testing whether implied volatilities predict subsequent excess returns on currency positions. I find they do, a rejection of simple efficiency. More important, since theory links volatility to the risk premium, this provides a stronger basis for interpreting rejection of the joint hypothesis as evidence of a risk premium, as opposed to a violation of rational expectations. I also test a model of the risk premium that specifies an explicit relation between the premium and volatility.