Carry on speculating on the volatility of foreign
exchange
Pasquale Della Corte Lucio Sarno Ilias Tsiakas
26 January 2011
The carry trade in foreign currency has attracted considerable attention from academics and
practitioners. This column presents evidence of a new carry trade strategy – this time speculating
on the volatility of foreign exchange. This is done by buying or selling forward volatility
agreements. It suggests that investors following the new carry trade can do extremely well –
regardless of whether the value of these currencies go up or down.
The standard “carry trade” is a popular currency speculation strategy that invests in high-interest
currencies by borrowing in low-interest currencies. This strategy works well if, for example, spot
exchange rates are unpredictable. There is ample empirical evidence pointing in that direction or,
in academic jargon, showing that exchange rates follow a random walk (Meese and Rogoff 1983).
In this case, investors engaging in carry trading will on average earn the difference in interest
rates without having to worry about movements in exchange rates. The return to currency
speculation can be substantial over time. It should be no surprise, therefore, that the carry trade
has attracted considerable attention from academics and practitioners over the years.
Speculating on volatility
In recent years, investors have been able to speculate not only on the value of currencies but
also on the level of volatility of these currencies. This has become possible by trading a contract
called the forward volatility agreement (FVA), which effectively allows investors to trade volatility.
Technically speaking, the FVA is a forward contract on future spot implied volatility, which for a
one dollar investment delivers the difference between future spot implied volatility and forward
implied volatility. To make our terminology clear, implied volatility is a measure of expected
volatility, which is directly quoted in traded currency options (Jorion 1995). When we say “spot”
implied volatility we mean the implied volatility for an interval starting today and ending in the
future (e.g., starting today and ending one month from now). “Forward” implied volatility is the
implied volatility determined today for an interval starting in the future and ending further in the
future (e.g., starting in one month and ending in two months from now).
The main point of the FVA is that it allows investors to speculate on the level of future volatility.
Then, the “carry trade in volatility” is a speculation strategy that buys and sells FVAs, where
investors try to make money by guessing the level of future spot implied volatility. Similar to the
standard carry trade, the carry trade in volatility works well if spot implied volatility is
unpredictable. Then, investors engaging in this new carry trade will on average earn the
difference between spot and forward volatility without having to worry about movements in
exchange rates.
Is forward volatility a good predictor of future volatility?
The FVA sets a forward implied volatility by making a guess about future spot implied volatility.
For example, today it might set a forward volatility of 10% for the period starting in one month and
ending in two months from now. This forward volatility is meant to be an unbiased predictor of the
future spot implied volatility for the same period, which may end up being higher or lower than
10%. As any forward contract, the FVA is designed so that on average the ex ante forward
volatility matches the spot volatility that happens ex post. 1 If these two volatilities end up being
very similar, buying and selling FVAs will not be profitable and the carry trade in volatility will not
work. In this case, speculating on volatility will not generate profits. But is this the case?
In a recent paper (Della Corte et al. 2010), we investigate the systematic relation between spot
and forward volatility in foreign exchange by estimating the volatility analogue to the famous
Fama regression (Fama 1984). Using a number of currencies, alternative measures of volatility,
and different estimation techniques, we find a fairly robust result. Forward volatility is a poor
predictor of future spot implied volatility. This is called the “forward volatility bias.” In fact, for
some cases, the relation between spot and forward volatility is practically non-existent, which
implies that spot volatility may be close to a random walk. This is a strong result with important
implications.
Is volatility speculation profitable?
If forward volatility is a poor predictor of future spot implied volatility, buying and selling FVAs can
be very profitable. For example, buying (selling) FVAs when forward implied volatility is lower
(higher) than current spot implied volatility will consistently generate excess returns over time.
Even better, we show that investors can design simple dynamic asset allocation strategies that
exploit the forward volatility bias. These strategies can consistently generate high profits even
when the transaction cost of trading FVAs is rather high. Similar strategies assuming that spot
volatility follows a random walk generate equally high profits.
Another important result is that the returns to the standard carry trade in currency and the carry
trade in volatility tend to be uncorrelated over time. This point can be seen clearly in Figure 1,
which shows the annualised out-of-sample Sharpe ratios for the standard carry trade in currency
and the carry trade in volatility, labelled CTC and CTV respectively. The Sharpe ratio is simply
defined as the excess return of each strategy per unit of risk. The CTV strategy tends to perform
better at the beginning and end of the sample, whereas the CTC is better in the middle period.
Moreover, it is interesting to note that for the last two years of the sample the Sharpe ratio of the
CTV strategy is rising but that of the CTC is falling. This indicates that the CTV strategy has done
well during the recent credit crunch when the CTC has not.
Figure 1.
Conclusion
There is money to be made in trading foreign-exchange volatility. If there is a bias in the way the
market sets forward volatility, then the carry trade in volatility strategy will be profitable. We find
strong statistical and economic evidence that this is indeed the case. Hence, there is a new carry
trade. Finally, our empirical findings on volatility speculation can provide valuable insight to
market participants and policymakers who can benefit from taking a stance on the future volatility
in currencies.
References
Della Corte, P, L Sarno, and I Tsiakas (2010), “Spot and Forward Volatility in Foreign Exchange”,
Journal of Financial Economics, forthcoming. Centre for Economic Policy Research Discussion
Paper 7893.
Fama, EF (1984), “Forward and Spot Exchange Rates”, Journal of Monetary Economics, 14:319338.
Jorion, P (1995), “Predicting Volatility in the Foreign Exchange Market”, Journal of Finance,
50:507-528.
Meese, RA and K Rogoff (1983), “Empirical Exchange Rate Models of the Seventies: Do They Fit
Out of Sample?”, Journal of International Economics, 14:3-24.
Technically speaking, as any forward contract, the FVA’s net market value at entry must be
equal to zero. Therefore, its exercise price (forward implied volatility) represents the risk-neutral
expected value of future spot implied volatility. Hence the former must be an unbiased predictor
of the latter.
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