The U.S. Dollar and variance risk premia imbalances

Abstract

We present a novel predictor for the Dollar factor: variance risk premia imbalances (VPI), defined as the difference in variance risk premium between the U.S. and non-U.S. countries. We argue that VPI theoretically proxies the average volatility differential between the U.S. and non-U.S. stochastic discount factors. VPI significantly predicts monthly U.S. dollar movements, explains roughly 10% of next-month Dollar factor variation, and generates significant economic value for investors. We rationalize our findings in a simple consumption-based asset pricing model.