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.