Global Variance Risk Premium and Forex Return Predictability

In a long-run risk model with stochastic volatilityand frictionless markets, I express expected forex returns as a function of consumption growth variances and stock variance risk premiums(VRPs)—the difference between the risk-neutraland statistical expectations of market return variation. This provides a motivation for using the forward-looking information available in stock market volatility indices to predict forex returns. Empirically, I find that stock VRPs predict forex returns at a one-month horizon, both in-sample and out-of-sample. Moreover, compared to two major currency carry predictors, global VRP has more predictive powerfor currency carry trade returns, bilateral forex returns, and excess equity return differentials.