A1576
Title: Extreme volatility risk and FX returns
Authors: Josef Kurka - UTIA AV CR, v.v.i. (Czech Republic) [presenting]
Abstract: While there is a large literature explaining the risk premia on the stock markets, much less is known about the mechanisms generating the foreign exchange (FX) risk premia. We believe that one of the prominent reasons for the failure to explain the currency risk premia is that preferences are modelled as homogeneous across all investors with regard to the risk tastes, and the risk-return relationship is modelled as linear in risk. Volatility is known to be an important indicator of risk and a crucial pricing factor across different assets, and it is also closely connected to the currency risk premia, however, it has also been modelled to have a linear impact across the whole distribution. In contrast, we propose to employ the Extreme Volatility Risk Factor, which should be of the highest relevance to the risk-averse investor cautious mainly about the tails of currency returns distribution, and should be an important step towards explaining the Forward rate bias puzzle. The empirical results suggest that Extreme Volatility is significantly priced in the cross-section of FX returns.