Foreign Exchange Research

16 June 2014

The FX volatility risk premium

Identifying drivers and investigating
returns
FX Strategy
Interest in alternative sources of return in FX has increased as the more prevalent
Aroop Chatterjee
systematic trading strategies such as carry, value, and trend have become +1 212 412 5622
increasingly commoditized. One such source is the volatility risk premium (VRP), [email protected]
which, in its most basic form, requires selling volatility to exploit the persistent
difference between implied and realized volatility. In a recent publication, Investing Systematic Strategies Research
in volatility across asset classes, November 2013, we provide a detailed, integrated Yuan Tian
+44 (0)20 7773 1436
cross-asset class discussion of this risk premium. Here, we focus on the currency
[email protected]
markets – highlighting asset class specific drivers, outlining simple tradable
implementations, and discussing the risk premium in a wider FX portfolio context for Kartik Ghia
thematic investors. +1 212 526 4054
[email protected]
• Historically, the return profile is similar to that of an insurance underwriter; the
ex-post realized volatility tends to be slightly lower than the ex-ante implied www.barclays.com
volatility over extended periods (booking a premium), interspersed with sudden,
large reversals (as risk events materialize).

• The expected excess return is driven by market structure and investor behavior –
in particular, investors’ willingness to buy protection/insurance against adverse
market events. The rapid growth in options market liquidity has made the volatility
risk premium easier to access.

• The cross-sectional variation of the volatility risk premium reflects the various
demand and supply factors of this insurance. We show the VRP increasing under
demand pressures such as the currency’s beta to volatility and size of cross-border
exposures, whereas VRP is lower for currencies that are easier to hedge (less sensitive to
funding pressures) and where central banks are aggressive in their market interventions.

• There are few natural sellers of volatility, while a wide range of buyers exists.
Following the credit and sovereign debt crisis, this imbalance tends to be accentuated.
The premium received reflects the asymmetric nature of the risk taken by market
makers, which is both difficult to diversify and operationally intensive to manage.

• Our findings suggest that investors can harvest a global FX volatility premium.
Tradable structures such as vol swaps provide direct exposure to this volatility premium.
Liquidity remains a big consideration for trading these instruments in large notional, and
options-based strategies are the most popular access route for investors.

• The slope characteristics of the term structure, along with risk reversals, appear
to be leading indicators of the VRP. The analysis suggests that metrics can be
derived to construct tactical exposure to the VRP.

• Attractive portfolio characteristics: Currency VRP returns are an attractive addition

to the portfolios of both FX investors with exposure to traditional style-based
strategies and investors with exposures to the equity VRP.

PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES STARTING AFTER PAGE 17
Barclays | The FX volatility risk premium

The volatility risk premium (VRP) refers to the persistently positive difference between implied
volatility and future realized volatility (Canina and Figlewski [1993] and Lamoreux and Lastrapes
[1993] represent early work documenting its existence). A substantial body of literature has
documented the existence of VRP in different asset classes (e.g., Buraschi, Trojani and Vedolin
[2014], Mueller, Vedolin and Yen [2012], Todorov [2009], Londono and Zhou [2012], Bollersley,
Gibson and Zhou [2011]). These typically find that market expectations for future volatility
(implied volatility) tend to be higher than future realized volatility on average. Investors earn a
positive expected return over time for selling volatility (and earning the VRP) with the risk of large
drawdowns when realized volatility moves sharply higher.

Our aims are two-fold. First, we wish to document the existence of a volatility risk premium
in FX, the reasons it may exist, and what may explain its variation in the cross-section and
over time. Second, we aim to provide simple strategies for accessing the FX VRP and
characterize these returns versus other risk premia in FX and other asset classes.

Is there a volatility risk premium in FX?

If VRP exists in FX, a market participant who is willing to sell volatility should expect to earn, on
average, a positive return over time. Figure 1 presents descriptive statistics for a naïve vol selling
strategy on a currency-by-currency basis for G10 and major EM currencies. The strategy involves
selling volatility through a one-month volatility swap (“vol swap”) at the end of each month. At
maturity, the payoff of the vol swap is given by the difference between 1m realized volatility on
that date minus the implied volatility strike for the vol swap. We note that returns reported in
Figure 1 do not take into account transaction costs and are merely for expositional purposes.

A strategy to sell volatility earns a positive expected return across all G10 and EM currencies in
our sample (2005-14). The average return can be thought of as the size of the available VRP in
each currency. The return volatility varies, however. Risk-adjusted returns (information ratios)
range from 0.2 to 2.5 for the various currencies. The highest IRs are in reserve currencies (EUR
and JPY), as well as highly managed EM currencies (HKD, CLP and INR). In general, it appears
that EM currencies have a higher IR level from earning VRP than G10.

The skewness in returns also makes for interesting reading. As would be expected in a
strategy that earns risk premium, return skewness is by and large negative, i.e., investors risk
drawdowns for earning the VRP. There are a few notable exceptions, such as EUR, JPY, and
GBP, that have positive skewness of returns. We re-visit this in a later section when discussing
tradable portfolios.

FIGURE 1
Summary statistics for the VRP across G10 and EM currencies
AUD BRL CAD CHF CLP EUR GBP HKD ILS INR JPY MXN NOK NZD PLN RUB SEK SGD TRY ZAR

Mean (% ann) 0.3 0.5 1.2 0.6 3.2 1.7 1.1 0.2 1.2 1.9 1.5 2.3 0.5 0.5 1.5 1.9 0.7 1.1 0.9 1.4

Std. dev (% ann) 1.8 2.6 0.6 1.0 1.5 0.7 0.6 0.1 0.7 1.0 1.0 2.0 1.1 1.2 1.5 1.1 0.9 0.5 1.7 1.8

IR (ann) 0.2 0.2 1.8 0.6 2.2 2.5 1.9 2.4 1.7 2.0 1.5 1.2 0.5 0.4 1.0 1.7 0.8 2.0 0.5 0.8

Skewness (monthly) -4.1 -4.6 -1.1 -2.1 0.0 0.6 0.3 -2.3 -0.7 -0.9 0.8 -3.1 -0.9 -0.7 -0.5 -0.2 -0.6 -0.9 -3.4 -3.6

Max drawdown -3.8 -6.3 -1.3 -2.0 -2.5 -1.0 -0.7 -0.3 -1.3 -1.9 -2.0 -4.2 -1.5 -1.9 -3.0 -2.1 -1.2 -0.9 -3.8 -4.2

Source: Barclays Research

16 June 2014 2
Barclays | The FX volatility risk premium

FIGURE 2
VRP strategy IRs conditioned on the state of the world (realized vol quintile)

IR
14
12
10
8
6
4
2
0
-2
-4

PLN

SGD
BRL

ILS

JPY

SEK
MXN

TRY

ZAR
AUD

CHF

CLP

GBP
EUR

HKD

RUB
INR

NZD
CAD

NOK
[1] [2] [3] [4] [5]
Source: Barclays Research

Why does it exist in FX?

The level of implied volatility captures the cost of insurance against adverse market
movements, i.e., higher future realized volatility. The presence of a VRP implies that the sellers
of this insurance need to be compensated with a positive expected return over time. In other
words, in the good (bad) state of the world, a VRP strategy tends to deliver positive (negative)
returns and, hence, correlates positively with investors’ consumption/wealth. This positive
beta to consumption/wealth requires compensation. Bakshi and Madan (2006) discuss the
link between the return distribution of the VRP and investor risk aversion. Rising volatility in
times of increasing market uncertainty leads sellers to suffer negative returns and large
drawdowns, resulting in negatively skewed returns.

Figures 2 and 3 show the IRs and skewness from the VRP strategy conditioned on the level
of realized vol in each month. We consider quintiles of the level of realized vol and find that
in the highest realized vol quintile (signified as [5]), the VRP strategy earns the lowest
(typically negative IR) on average, as well as the largest negative skewness in returns.

FIGURE 3
VRP strategy skewness conditioned on the state of the world (realized vol quintile)

Skewness
3
2
2
1
1
0
-1
-1
-2
-2
-3
PLN

SGD
BRL

ILS

JPY

SEK
MXN

TRY

ZAR
AUD

CHF

CLP

GBP
EUR

HKD

RUB
INR

NZD
CAD

NOK

[1] [2] [3] [4] [5]

Source: Barclays Research

16 June 2014 3
Barclays | The FX volatility risk premium

FIGURE 4
VRP strategy IRs conditioned on funding pressure (risk-adjusted TED spread quintile)

IR
10

-2

-4

PLN

SGD
BRL

ILS

JPY

SEK
MXN

TRY

ZAR
AUD

CHF

CLP

GBP
EUR

HKD

RUB
INR

NZD
CAD

NOK
[1] [2] [3] [4] [5]
Source: Barclays Research

The imbalance between the number of buyers and sellers of volatility is a possible
contributing factor to the existence of the volatility risk premium. There are few true sellers
of volatility in the market, while plenty of buyers exist. Since volatility is in low net supply,
market makers/dealers tend to have a short vol position. Funding and/or leverage
constraints on these market participants may dictate the size of the volatility risk premium
(this is in the spirit of the limits of arbitrage emphasized by Schleifer and Vishny [1997]). For
example, if funding is further constrained, we would expect the market price for insurance
to rise, increasing the level of risk premium available to vol-selling investors. In general, for a
given state of the world (i.e., the level of volatility), the return from a VRP strategy should be
an increasing function of funding pressure.

To examine this, we run regressions of a proxy for funding pressures – the TED spread – on
the level of realized volatility in each currency. The residuals from these regressions may be
considered as the level of funding pressures conditioned on the state of the world. We then
examine the returns from the canonical VRP strategy in quintiles of this risk-adjusted

FIGURE 5 FIGURE 6
VRP and currency sensitivity to adverse market movements VRP and cross-border positions (equity and bonds) vs the US
2.5% Average 2.5%
Average
VRP VRP y = 0.0028x + 0.0102
2.0% 2.0% R² = 0.0543

1.5% 1.5%

1.0% 1.0%

y = -0.0233x + 0.007
0.5% R² = 0.1924 0.5%

0.0% 0.0%
-0.5 -0.4 -0.3 -0.2 -0.1 0 0.1 -100% -50% 0% 50% 100% 150%
Beta to realized vol Net cross border position vs US/Gross position
Note: We look at spot return betas to changes in realized volatility. Source: Note: The size of positions are as of 2011 as published by the IMF. Source:
Barclays Research Barclays Research

16 June 2014 4
Barclays | The FX volatility risk premium

funding pressure measure. The results are shown in Figure 4. They seem to back up our
intuition that higher funding pressures/balance sheet constraints for market participants
(specifically those selling insurance to the market) are likely to leave higher levels of risk
premium on the table for vol-selling investors (i.e., returns tend to be higher during periods
of high funding pressure – quintile [5] – than when it is low – quintile [1]).

Explaining the cross-section of VRP in FX

We now examine how the VRP varies in the cross-section of currencies. The price of
insurance – the VRP – reflects a variety of demand and supply factors.

Factors capturing the demand for insurance

Garleanu, Pederson and Poteshman (2009) illustrate that demand pressure tends to boost
the prices of options/insurance, specifically by the amount that is unhedgeable. The
primary factor driving the demand for insurance is investors’ aversion to volatility and the
need for downside protection, with investors willing to pay a higher price for insurance for
currencies that have a higher beta to realized volatility. Figure 5 shows that the average VRP
for various currencies is negatively related to their betas to realized volatility.

The level of demand for insurance is also dependent on the market’s need to hedge
currency exposures. A significant mismatch in cross-border ownership of assets would be
expected to lead to supply/demand imbalances for US dollars in the event that exposures
need to be hedged. For example, a high level of US ownership of local currency assets
relative to the currency liquidity (a proxy for which is the gross cross-border position) would
be expected to result in a higher price for insurance. On the other hand, a higher net cross-
border ownership of US assets versus the foreign currency implies a greater supply of
liquidity/insurance available for hedging. Figure 6 shows that this intuition holds true for the
currencies of countries that would result in both net demand and supply of US dollars.

Factors capturing the supply of insurance

In the discussion above, we noted that as funding pressures increase, balance sheet
constraints on vol sellers are expected to become binding, reducing the supply of insurance

FIGURE 7 FIGURE 8
VRP and currency sensitivity to funding pressures VRP and FX market intervention by central banks
2.5% Average 2.5% Average
VRP EM VRP

2.0% y = -0.7864x + 0.0094 2.0% y = -0.6955x + 0.0142

G10
R² = 0.4155 R² = 0.1057
1.5%
1.5%

1.0%
1.0% y = 0.2225x + 0.0121
R² = 0.3945
0.5%
0.5%

0.0%
0.0% 0.0% 0.2% 0.4% 0.6% 0.8% 1.0% 1.2%
-0.04 -0.03 -0.02 -0.01 0 0.01 0.02
Std. dev. of change in reserves as % GDP
Beta to funding pressure
Note: The currency’s sensitivity to the changes in funding pressures is measured Note: The aggressiveness of the central bank’s FX market intervention is proxied
by its spot return beta to changes in the TED spread after controlling for the level by the standard deviation of the change in reserves after accounting for
of realized volatility. Source: Barclays Research valuation changes normalized by annual GDP. Source: Barclays Research

16 June 2014 5
Barclays | The FX volatility risk premium

and driving up the price. We expect a currency that is more sensitive to funding issues (more
negative beta of returns to funding pressures) to be more costly to hedge. This would imply a
negative correlation between the average VRP and a currency’s beta to funding pressures.
To avoid picking up on the correlation between funding pressures and volatility, we
consider the residual from a regression of funding pressures on volatility. Figure 7 shows
that the relative exposure to funding pressures does lead to higher VRP specifically for EM
currencies. Without controlling for other variables, this effect does not appear to translate
into higher vol for G10 currencies, however.

In a number of emerging markets, central banks are the key provider of insurance to the
market. Ex-ante, one would expect a more aggressive central bank and/or a currency
regime that is closer to being pegged to result in a lower market price for insurance. The
aggressiveness of central banks in managing FX market liquidity may be proxied by the
standard deviation of the changes in reserves as a percentage of GDP. Figure 8 shows that
for both G10 and EM currencies, the average VRP is lower as central banks become more
aggressive in their FX interventions.

Putting it all together

We put all of this together in Figure 9. Different multivariate regression specifications for
explaining the level of risk premium generated from a vol selling strategy are considered.
We find that a beta to vol of -1 correlates with a higher VRP of around 3-4% annually on
average in the full set of currencies (specifications [1] and [2]). This effect tends to be
weaker after accounting for the higher level of EM VRP (specification [3]), as well as
considering different effects in G10 and EM currencies (specification [4]).

The importance of supply constraints is captured by the coefficient on the currency’s beta
to funding pressures. We find that after controlling for a currency’s beta to vol, this variable
has limited explanatory power for the cross-sectional distribution of the VRP (and does not
have the correct signs in specifications [1], [2], and [3]). In EM currencies, however, a more
negative beta to funding pressures leads to a higher VRP even after controlling for other
explanatory variables.

The level of VRP in EM tends to be higher, on average, even after controlling for other
explanatory variables (specification [3]). This difference is about 84bp annually and is found
to be statistically significant. Perhaps most surprising, the aggressiveness of the central
bank in smoothing FX market movements is found to be a consistent driver of the VRP for
both G10 and EM currencies (specification [4]).

16 June 2014 6
Barclays | The FX volatility risk premium

FIGURE 9
Regressions of the VRP on different explanatory variables

[1] [2] [3] [4]

-0.0324*** -0.0396* -0.0132 0.0108
Beta to vol
(0.0072) (0.0204) (0.0168) (0.0084)
0.1356 0.1968*** 0.0324 0.1368***
Beta to funding pressures
(0.126) (0.0792) (0.1128) (0.0216)
-0.0048 -0.006 -0.0024
Net cross border position
(0.0048) (0.0048) (0.0012)
-0.072 -0.2148* -0.2244***
FX intervention
(0.0984) (0.1176) (0.0612)
-0.0588***
Beta to vol*EM
(0.0072)
-0.6564***
Beta to funding pressures*EM
(0.0552)
-0.0108***
Net cross border position*EM
(0.0012)
-0.6732***
FX intervention*EM
(0.0612)
0.0084***
EM
(0.0024)
0.0072*** 0.0096*** 0.0096*** 0.0132***
Const
(0.0024) (0.0024) (0.0036) (0.0012)
R-squared 0.24 0.31 0.41 0.83
Note: *** Denotes 99% confidence, ** is 95% confidence, and * is 90% confidence to reject the null hypothesis that the
coefficient is zero. Source: Barclays Research

Accessing the volatility risk premium

We now examine a rule-based approach to accessing the VRP with an eye on tradability. We
begin by outlining the performance profile for individual currency pairs followed by a multi-
currency portfolio. In order to facilitate tradability, we focus on the most liquid options
among the G10 currencies – EURUSD, GBPUSD, AUDUSD, USDJPY, and USDCAD. Where
available, we construct historical return series beginning in 1997 using data from the CME
and Bloomberg.1 For reference, a long position in the volatility risk premium is accessed by
taking a short position in straddles/strangles. All our results are presented net of costs, and
exposures are delta-hedged daily in order to isolate the volatility risk premium from
underlying price movements. A cost comparison between equities and FX options requires
that costs be compared accounting for differences in volatility. On a like-for-like basis, the
average transaction cost of trading a one-month straddle rolled every month is
approximately 1% per annum, compared with 1.5% for SPX options rolled on the same
frequency. The appendix contains a more detailed analysis.

1
As liquidity in the currency options market increases, we expect to expand this analysis to a wider G10 and EM
universe.

16 June 2014 7
Barclays | The FX volatility risk premium

Long-only passive portfolios

Investors are able to isolate and capture the difference between the implied volatility level and
the realized volatility by constructing a short straddle or strangle position and delta hedging it
daily. We construct a return series (net of costs) for both individual currencies and an
aggregate portfolio comprising all five currencies based on short positions in one-month
ATMF strangles. Figure 10 displays the summary performance statistics over the full sample
period. As shown, there is a marked difference in performance over the two sub-sample
periods with the exception of AUDUSD, which performs poorly for the duration of the analysis.

A benchmark long-only VRP portfolio can be constructed by equal-weighting the individual

currency VRP strategies. The long-only portfolio has a lower volatility as a result of
diversification in the full sample, as well as in the sub-sample periods.

FIGURE 10
Short 1m straddles on liquid G10 currencies: Performance statistics (1997-2014)
GBP CAD JPY AUD EUR Portfolio

Full sample (1997-2004)

Ann returns 0.6% 0.4% 0.5% -1.5% 0.5% 0.1%
Volatility 1.5% 1.7% 2.5% 2.3% 1.7% 1.3%
Sharpe ratio 0.41 0.21 0.21 -0.65 0.30 0.11
Max drawdown -6.7% -6.5% -11.3% -21.6% -6.1% -7.9%
Skewness 0.63 0.87 -1.24 -0.86 0.28 0.11

1st half (1997 – 2005)

Ann returns 0.5% 0.3% -0.9% -1.1% 0.0% -0.2%
Volatility 1.3% 1.3% 2.6% 1.4% 1.5% 1.2%
Sharpe ratio 0.35 0.24 -0.35 -0.76 0.01 -0.13

2nd half (2006 – 2014)

Ann returns 0.7% 0.4% 2.1% -1.8% 0.9% 0.5%
Volatility 1.6% 2.1% 2.3% 2.7% 1.8% 1.5%
Sharpe ratio 0.46 0.20 0.90 -0.64 0.51 0.33
Source: Barclays Research

Time varying performance of a long-only VRP strategy

A look at the semi-annual returns in Figure 11 shows times variation in the long-only
portfolio’s performance. There appear to have been three distinct phases: 1) 1997-2002,
when returns were mixed, 2) 2003-07, when returns were negative, and 3) 2008 onward,
which saw predominantly positive returns. Sharpe ratios for the corresponding periods were
0.23, -1.2, and 0.6, respectively.

Periods of better performance tend to follow crisis periods – the returns for a long-only VRP
strategy rise after large jumps. Todorov (2009) finds that the willingness to pay for
insurance – the level of the VRP or, in other words, the level of implied vol – is higher; hence,
a strategy that sells vol to earn the VRP does well following such episodes. This is reflected
in Figure 11, which shows a positive return in every quarter following a major event with the
exception of the 9/11 attacks.

16 June 2014 8
Barclays | The FX volatility risk premium

FIGURE 11
Semi-annual returns vary over time

Quarterly returns
2.0%

1.5% Dotcom
Bubble
9/11
1.0% Talk of
attacks
Fed
taper
0.5%

0.0%

-0.5% Greek
Asian Start of the default
-1.0% Crisis Credit Crisis
Russian
Default
-1.5%
Sep 97 Sep 99 Sep 01 Sep 03 Sep 05 Sep 07 Sep 09 Sep 11 Sep 13

Source: Barclays Research

This also implies that the long-only VRP strategy will correlate negatively with implied vol (the
Barclays G10 risk aversion index, BXIIVG10 Index) 2 contemporaneously and positively with
lagged implied vol (one-month lag). Based on monthly returns, we calculate the 24-month
rolling correlation between portfolio returns and changes in volatility. From Figure 12, we see a
persistently negative contemporaneous correlation between changes in implied volatility and
returns. The correlation in lagged changes is more variable, however.

A shock to implied vol is likely also to lead to higher volatility of implied volatility and, hence, a
positive correlation with the long-only VRP strategy. We look at annual returns for the short
straddle portfolio and the corresponding volatility (based on monthly returns) of the Barclays
G10 risk aversion index. Figure 13 indicates a positive relationship with volatility of implied
volatility and has an R-square of 0.42. This suggests that during period when the volatility of
volatility is relatively elevated, the market tends to overestimate future realized volatility.

FIGURE 12 FIGURE 13
Rolling correlation: Portfolio returns vs FX implied volatility Portfolio returns versus the volatility of implied volatility

Correlation Ann returns

0.8 3.0% y = 0.0041x - 0.0116
Contemporary changes (implied vol) R² = 0.4239
0.6 2.5%
0.4 Lagged changes (implied vol) 2.0%
1.5%
0.2
1.0%
0.0
0.5%
-0.2
0.0%
-0.4 -0.5%
-0.6 -1.0%
-0.8 -1.5%
-1.0 -2.0%
01 02 03 04 05 06 07 08 09 10 11 12 13 14 0 2 4 6 8 10
Volatility of FX implied vol index (annualised)
Source: Barclays Research Source: Barclays Research

2
It measures the daily level of implied volatility based on a liquid basket of G10 currency options (3-month ATFM).

16 June 2014 9
Barclays | The FX volatility risk premium

FIGURE 14 FIGURE 15
VRP versus lagged changes in risk reversals VRP versus lagged levels of the (term structure) slope

3% 3%

2% 2%

1% 1%

VRP
VRP

0% 0%

-1% y = 0.8105x + 0.0048 -1%

R² = 0.298 y = 0.2034x + 0.0032
-2% -2% R² = 0.4209
-1.5% -0.5% 0.5% 1.5% -4.0% -2.0% 0.0% 2.0% 4.0% 6.0%
Vol adjusted risk reversals Vol adjusted slope
Source: Barclays research Source: Barclays research

In addition, crisis periods should lead to a higher price of deep-OTM put options (versus
calls, as the demand/price for insuring extreme moves rises) and a steeper vol curve slope
(as a higher vol of implied vol is priced into the curve). We would expect a positive
relationship between returns of the long-only VRP strategy and the lagged risk reversal
(normalized by the level of realized vol), as well as the lagged slope of the vol curve.

We examine these relationships using monthly data for the aggregate basket. Each month,
we calculate the realized VRP (implied vol minus realized vol at expiry) on an equal-
weighted basket (without netting out transaction costs) and the lagged change in the
basket’s risk reversal3 after adjusting by the realized volatility of each currency pair (again
equal-weighted). We look at 12-month averages for both the VRP strategy return and the
change in risk reversals. The results are illustrated in Figure 14 and show a clear positive
relationship. Repeating this analysis for the change in risk reversals by lagged values of the
(term structure) slope, we see a similar positive relationship (Figure 15).

Another way to view the relationship between the VRP and risk reversals and slope size is by
sorting the monthly changes into quartiles. This has the added benefit of reducing the noise
in the relationship given the less granular partition. Figures 16 and 17 indicate that the VRP
is significantly smaller (and negative) when both the slope and risk reversals are
negative/small relative to the full sample. Figure 16 suggests that the VRP is an increasing
function of the size of the risk reversal, whereas Figure 17 indicates that investors can
enhance returns simply by avoiding long exposure to the VRP when the slope is relatively
shallow (or negative).

3
Using 10-delta risk reversals

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Barclays | The FX volatility risk premium

FIGURE 16 FIGURE 17
Classifying returns: VRP by relative change in risk reversals Classifying returns: VRP by relative size of slope
1.2% 1.0%

1.0% 0.8%
0.8%
0.6%
0.6%
0.4%
VRP

VRP
0.4%
0.2%
0.2%
0.0%
0.0%

-0.2% -0.2%

-0.4% -0.4%
Quartile 1 Quartile 2 Quartile 3 Quartile 4 Quartile 1 Quartile 2 Quartile 3 Quartile 4
Source: Barclays research Source: Barclays research

Long-only selective portfolios

Having discussed the drivers of VRP, we briefly examine methods to take on selective
exposure instead of passive exposure to a long-only basket. The first method borrows from
the popular carry-style investing and uses the size of the expected (or ex-ante) volatility risk
premium to rank currency pairs. In this analysis, we rank currencies in descending order –
hence, portfolios 1 and 5 contain the most- and least-preferred currencies. The second
method extends the quartile analysis in the section above to time exposure to the VRP. For
simplicity, we look at monthly rebalancing, which coincides with the tenor of the FX options.

Size of the VRP based on historical realized vol

The expected volatility risk premium (EVRP) may be defined as the difference between
current implied volatility and realized volatility. The implicit assumption in this case is that
level of historical realized volatility is a good predictor of the level of future realized vol, i.e.,
realized volatility follows a random walk. This is clearly a simplifying assumption given the
significant body of literature documenting the clustering of volatility.

Each month, we rank the five currencies based on the EVRP. Figures 18 and 19 display the
performance of the five portfolios over the full period. The results indicate little evidence
that the size of the EVRP constructed in this manner is a good predictor of future returns.
We believe this supports the use of alternative models for forecasting future vol, such as
GARCH for calculating EVRP.

Relative slope size

Given the highlighted relationship between slope size and the available VRP, we examine the
performance of tradable strategy based on it. Figures 16 and 17 indicate that the bottom
quartile for both the slope and risk reversals is potentially the weakest from an investor’s
perspective. We use a related measure to calculate a relative slope at each month-end to
assess the potential return in the upcoming month. We use two slightly different signals and
investment approaches, both producing similar results.

16 June 2014 11
Barclays | The FX volatility risk premium

FIGURE 18 FIGURE 19
Portfolios based on the expected VRP (2001-14) Index performance: Expected VRP portfolios

Sharpe Index
ratio 115 Portfolio 1 Portfolio 2
0.4
Portfolio 3 Portfolio 4
110
Portfolio 5
0.2 105

100
0.0
95

-0.2 90

85
-0.4 01 02 03 04 05 06 07 08 09 10 11 12 13
Portfolio 1 Portfolio 2 Portfolio 3 Portfolio 4 Portfolio 5
Source: Barclays Research Source: Barclays Research

In the first case, the signal is based on the average slope of the five currency portfolios.
Depending on the signal, we take a long or neutral position on the entire five-currency VRP
basket. In the second case, we look at the slope measure and invest (long/neutral) in the
VRP on a currency-by-currency basis.

The indicator used as the signal is the same for both approaches. At each month-end, we
measure the z-score of the slope based on a 63-day window using daily values of the
volatility-adjusted slope. Using statistical convention, we set the signal threshold at -1. For

FIGURE 20 FIGURE 21
Tactical investing: Risk-adjusted performance (2001-14) Charting returns: Indexed performance
Long-only Z-score measure Inde x level
Aggregate Per currenc 106
Long-only
Full sample (2004-14) Aggregate measure
104
Ann returns 0.3% 0.4% 0.5% Per currency measure
Volatility 1.4% 0.9% 1.0% 102
Sharpe ratio 0.21 0.44 0.51
100
Drawdown -6.5% -2.2% -3.1%
Drawdown/volatiltiy 4.54 2.53 3.22 98

Skewness 0.10 1.88 1.77 96

1st half (2004 - 08) 94

Ann returns -0.8% 0.1% 0.1%
92
Volatility 1.7% 0.9% 1.1% 04 05 06 07 08 09 10 11 12 13 14
Sharpe ratio -0.47 0.06 0.12

2nd half (2009-14)

Ann returns 1.3% 0.7% 0.8%
Volatility 1.2% 1.0% 0.9%
Sharpe ratio 1.08 0.67 0.85

Note: We use a signal based on the vol-adjusted slope to time exposure to the Source: Barclays Research
VRP. Please see text for more details. Source: Barclays Research

16 June 2014 12
Barclays | The FX volatility risk premium

all values in excess of -1, we are long the VRP for either the basket (approach one) or the
individual currency pair (approach two). The idea is to neutralize exposure to the VRP when
the slope is relatively low. For both tactical portfolios, the results comprise a basket trading
all five currency pairs. The performance of this signal-based approach is given in Figures 20
and 21. The tactical portfolios perform more consistently over the two sub-periods than the
passive long-only basket. Over the full-sample, risk-adjusted returns improve from 0.21 for
the long-only to 0.44 and 0.51 for the tactical portfolios. Downside risk also improves, as
seen from the significant reduction in drawdown and increase in the positive skewness.

Portfolio applications
The most common styles for FX rules-based investors include carry, trend (momentum),
and value. We compare returns from the FX volatility risk premium relative to the simple
G10 implementations of each of these styles. For the purposes of correlation analysis, we
use the non-selective/passive portfolio. The selective portfolio based on the vol-adjusted
slope is introduced when discussing the construction of style-based portfolios. For
simplicity, the tactical portfolio we choose is the one using the aggregate z-score measure.

Full-period and rolling (24-month) correlations are highlighted in Figures 22 and 23. Full
sample correlations, which are low to negative versus the three traditional styles, provide
only a partial picture. Rolling correlations suggest that conditional correlations vary between
0.5 and -0.7 versus carry, trend, and value strategies. To illustrate the diversification benefits
to carry investors, we highlight in grey the quarters in which the carry strategy experiences
losses in excess of 4%. For a majority of these periods, the correlation with FX VRP returns
is either negative or becomes less positive.

Based on monthly rebalancing, we construct a volatility-based portfolio consisting of all four

strategies. Because of the empirically observed difficulty in volatility-weighting volatility
strategies, we use the full-sample volatility of the FX VRP index to size the exposure of that
particular strategy. We display the performance for both the selective and the aggregate
VRP portfolios and construct cross-style portfolio returns. As Figure 24 highlights, the
outperformance of the selective basket relative to the aggregate VRP premium is driven
primarily by returns during the first half of the sample period. During the second half, both
VRP baskets provide attractive risk-adjusted returns. In a portfolio context, the performance
of both baskets provides an attractive addition to the traditional portfolio comprising carry,
value, and trend, given the offsetting return profiles pre- and post-2007.

FIGURE 22 FIGURE 23
Full period correlations (2002-14) Rolling correlation versus the FX VRP (2004-14)

Carry Trend Value VRP 1.0

0.8
Carry 1 0.00 -0.44*** 0.18*
0.6
Trend 1 0.14 -0.12 0.4
Value 1 -0.34*** 0.2
Correlation

0.0
FX VRP 1
-0.2
-0.4
-0.6
-0.8
-1.0
04 05 06 07 08 09 10 11 12 13 14
Carry strategy losses Carry Trend Value
Source: Barclays Research Source: Barclays Research

16 June 2014 13
Barclays | The FX volatility risk premium

FIGURE 24
Evaluating currency risk premia performance: 2004- 14
Individual strategies Style-based portfolios
FX VRP Carry, Value
FX VRP
Carry Trend Value selective and Trend CVT + FXVRP CVT + FXVRPS
(FXVRP)
(FXVRPS) (CVT)
Full sample (2004-14)
Ann returns 2.4% -0.4% 1.0% 0.3% 0.4% 1.3% 1.5% 2.0%
Volatility 9.5% 6.1% 9.1% 1.4% 0.9% 3.6% 3.3% 3.3%
Sharpe ratio 0.25 -0.07 0.11 0.21 0.44 0.35 0.46 0.62
Max drawdown -30% -15% -22% -7% -2% -5% -7% -4%
Skewness -0.44 1.18 1.56 0.90 1.87 0.73 0.38 0.96

1st half (2004-08)

Ann returns -1.3% 0.6% 3.1% -0.8% 0.1% 1.1% -0.6% 1.0%
Volatility 9.0% 6.8% 10.6% 1.5% 0.9% 3.7% 2.7% 3.1%
Sharpe ratio -0.14 0.08 0.29 -0.52 0.06 0.30 -0.24 0.32

2nd half (2009-14)

Ann returns 5.6% -1.3% -0.8% 1.2% 0.7% 1.4% 3.4% 3.0%
Volatility 9.7% 5.5% 8.3% 1.4% 1.0% 3.9% 3.7% 3.4%
Sharpe ratio 0.57 -0.23 -0.09 0.85 0.67 0.35 0.92 0.87
Source: Barclays Research

Figure 25 provides a graphical illustration to the data in Figure 24. While the addition of the
volatility risk premium led to an underperformance until 2007, the subsequent performance
has led to an improved return profile for investors. The full-period correlations in Figure 26
highlight the attraction for traditional equity investors; returns from the VRP are moderately
positively correlated with the MSCI index but remain unchanged for the other asset classes.
By contrast, returns from the FX VRP are uncorrelated over the full sample, between both
traditional asset class returns and the equity VRP.

FIGURE 25 FIGURE 26
Style-based FX portfolios: Effect of the VRP Asset class correlations: Equity versus FX VRP
Index MSCI GSCI USTs Eq vol FX vol
130
125 MSCI 1 0.43*** -0.24** -0.33** 0.16*
120
GSCI 1 -0.19* 0.44*** -0.02
115
110 USTs 1 -0.21** 0.07
105
Eq vol 1 0.07
100
95 FX vol 1
90
85
80
04 05 06 07 08 09 10 11 12 13 14
CVT CVT + FXVRP CVT + FXVRPS

Source: Barclays Research Source: Barclays Research

16 June 2014 14
Barclays | The FX volatility risk premium

Extensions and concluding thoughts

We have discussed some of the major drivers of the volatility risk premium in the cross-
section, as well as over time. Investors can source this risk premium through either passive
or active strategies using liquid instruments within a transparent rule-based framework to
augment existing portfolios. We examined the performance profile for passive investors and
outlined a few approaches to construct selective baskets.

While long-only access to the FX VRP does provide a diversified return stream for traditional
style-based investors, the ability to time access – tactical investing – is of significant interest.
Given the differences in conditional returns by the sign of the term structure slope, the
relative slope ranking, and the changes in risk reversals, we believe further investigation of
the feasibility of a signal-based investment strategy is warranted. Defining the investment
outlook by the relevant signal, VRP investors can either vary leverage while maintaining
long-only exposure or enter long/short positions. A simple rule-based approach looking at
the size of the vol curve slope and the change in risk reversals provides encouraging results.
We intend to examine these topics and investigate the implications for investors in
subsequent publications.

16 June 2014 15
Barclays | The FX volatility risk premium

APPENDIX
FX options: Trading cost analysis
The option trading cost of the five liquid currencies is in line with U.S. equity index options.
Figure 19 shows the indicative vega cost of trading straddles in G5 currency compared with
SPX-linked options.

FIGURE 27
Annual vega cost comparison
3.5%

3.0%

2.5%

2.0%

1.5%

1.0%

0.5%

0.0%
1998 2000 2002 2004 2006 2008 2010 2012
EURUSD GBPUSD AUDUSD
Source: Barclays Research

Once the costs of FX and equity options have been adjusted for by the ratio of implied
volatility, the average transaction cost of trading a one-month straddle rolled every month is
approximately 1% per annum, compared with 1.5% for SPX options rolled on the same
frequency. Given transaction costs, continuously delta-hedging option positions in FX is less
expensive (and, hence, more common) than in fixed income and commodities markets,
making “pure-play” volatility exposure easier to access.

16 June 2014 16
Barclays | The FX volatility risk premium

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16 June 2014 17
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