Variance risk premium and expected currency return: the story is different at the tails of the distribution

ABSTRACT This paper investigates the prediction power of variance risk premium of domestic currency over the currency return for five major emerging market currencies controlling after the impact of past exchange rate developments and asymmetries in the variance risk premium, and the dependence between variance risk premium and currency return at different quantiles. The OLS regression results show that higher (lower) variance risk premium leads appreciation (depreciation) of domestic currency against US Dollar and this relationship holds in after controlling asymmetries in the variance risk premium and past currency returns. Besides, the results don’t confirm an asymmetric effect of the variance risk premium and a linearly increasing effect of variance risk premium conditional on different quantiles of past currency return. Finally, quantile-on-quantile regression (QQR) results show that the negative association of variance risk premium and currency return reverse to be positive at the tails.