Information Content of Option Implied Eigenportfolios and Their Variance Risk Premium Sensitivities in G10 Currencies

Abstract

This paper reveals a novel way of constructing the option implied RX and HML_FX risk factors by utilizing the full cross-section of the 45 G10 cross-rate options. The option implied carry factors, IEP^{2,ZC}, are highly profitable strategies that surprisingly earn both positive carry and positive spot price contribution and stochastically dominate the traditional HML_FX. Moreover, the changes of 6m-1m variance risk premium slope of implied dollar factor, IEP^1 have predictive power on both IEP^{2,ZC} 's and HML_FX 's returns. We conclude the implied eigenportfolios to contain information to both improve the profitability of carry strategies via allocation and via predicting the strategy related risks.