We obtain ex ante estimates of risk premia for G10 currency pairs using cross-sectional data on exchange rate options. Option prices are well-matched by a non-Gaussian, two-factor model, consistent with evidence from realized currency returns. We find that option-implied currency risk premia provide an unbiased forecast of monthly currency excess returns, and achieve cross-sectional forecasting R^2s of up to 44%. Despite prominent non-normalities in option data, less than 20% of the model HML-FX risk premium, or roughly 70bps per annum, is due to the asymmetries and higher-moments of global risks.

Keywords: risk premia, currency carry trade, disaster risk, exchange rate options

Continue reading here.