The academic paper we review this week shows that a carry trade in volatility, a long-short strategy that buys implied volatility at a discount and sells implied volatility at a premium, generates a significant Sharpe ratio. The associated volatility returns are virtually uncorrelated with the traditional carry trade and other popular currency strategies.
The Study in a Nutshell
There is a growing body of literature documenting the existence of pronounced volatility risk premia, particularly in the short run. A new paper, published in the Journal of Financial Economics, investigates the properties of these premia in FX markets by examining the cross-sectional differences in the returns of forward volatility agreements (FVAs).
Their analysis yields two key results:
A zero-cost strategy that buys FVAs with downward sloping implied volatility curves and sells FVAs with upward sloping curves (a vol:carry strategy) generates significant excess returns.
The volatility carry premium remains both statistically and economically large for the implied volatility curve out to two years.
The proposed vol:carry (VCA) strategy outperforms the traditional FX carry trade strategy whereby an investor is long currencies with high yields and short currencies with low yields.
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