Volatility Shocks and Currency Returns
Abstract
This paper examines how shocks to currency volatilities predict exchange rates. Using option-implied volatilities, we construct a dynamic, directed network of volatility connections. Currencies that transmit more volatility shocks, which control for common correlation, earn lower excess returns. Buying the weakest and selling the strongest transmitters delivers high risk-adjusted performance, driven by spot exchange rate movements and not explained by standard factors. A general equilibrium model shows that volatility transmission related to idiosyncratic shocks proxies for priced country-specific risk. Assuming a monotonic amplification of domestic idiosyncratic risk, volatility transmission forecasts negatively future excess returns, consistent with the empirical evidence.
Keywords
Cite
@article{arxiv.2101.09738,
title = {Volatility Shocks and Currency Returns},
author = {Mykola Babiak and Jozef Barunik},
journal= {arXiv preprint arXiv:2101.09738},
year = {2026}
}