Sarno, Lucio (2010): Properties of Foreign Exchange Risk Premiums.
This is the latest version of this item.
Download (1MB) | Preview
Download (1MB) | Preview
We study the properties of foreign exchange risk premiums that can explain the forward bias puzzle, defined as the tendency of high-interest rate currencies to appreciate rather than depreciate. These risk premiums arise endogenously from imposing the no-arbitrage condition on the relation between the term structure of interest rates and exchange rates, and they compensate for both currency risk and interest rate risk. In the empirical analysis, we estimate risk premiums using an affine multi-currency term structure model and find that model-implied risk premiums yield unbiased predictions for exchange rate excess returns. While interest rate risk affects the level of risk premiums, the time variation in excess returns is almost entirely driven by currency risk. Furthermore, risk premiums are closely related to global risk aversion, countercyclical to the state of the economy, and tightly linked to traditional exchange rate fundamentals.
|Item Type:||MPRA Paper|
|Original Title:||Properties of Foreign Exchange Risk Premiums|
|Keywords:||term structure; exchange rates; forward bias; predictability|
|Subjects:||E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E43 - Interest Rates: Determination, Term Structure, and Effects
F - International Economics > F3 - International Finance > F31 - Foreign Exchange
G - Financial Economics > G1 - General Financial Markets > G10 - General
|Depositing User:||Christian Wagner|
|Date Deposited:||27. Apr 2011 09:49|
|Last Modified:||06. Nov 2014 19:45|
Ahn, D.-H. (2004). Common factors and local factors: Implications for term structures and exchange rates. Journal of Financial and Quantitative Analysis, 39:69--102.
Almeida, C. and Vicente, J. (2008). The role of no-arbitrage on forecasting: Lessons from a parametric term structure model. Journal of Banking and Finance, 32:2695--2705.
Anderson, B., Hammond, P. J., and Ramezani, C. A. (2010). Affine models of the joint dynamics of exchange rates and interest rates. Journal of Financial and Quantitative Analysis, 45:1341--1365.
Andrews, D. (1991). Heteroskedasticity and autocorrelation consistent covariance matrix estimation. Econometrica, 59:817--858.
Ang, A. and Piazzesi, M. (2003). A no-arbitrage vector autoregression of term structure dynamics with macroeconomic and latent variables. Journal of Monetary Economics, 50:745--787.
Bacchetta, P. and van Wincoop, E. (2009). Infrequent portfolio decisions: A solution to the forward discount puzzle. American Economic Review, 100:870--904.
Backus, D. K., Foresi, S., and Telmer, C. I. (2001). Affine term structure models and the forward premium anomaly. Journal of Finance, 56:279--304.
Backus, D. K., Gregory, A. W., and Telmer, C. I. (1993). Accounting for forward rates in markets for foreign currency. Journal of Finance, 48:1887--1908.
Bakshi, G. and Chen, Z. (1997). Equilibrium valuation of foreign exchange claims. Journal of Finance, 52:799--826.
Bansal, R. (1997). An exploration of the forward premium puzzle in currency markets. Review of Financial Studies, 10:369--403.
Bansal, R. and Dahlquist, M. (2000). The forward premium puzzle: Different tales from developed and emerging countries. Journal of International Economics, 51:115--144.
Bansal, R., Gallant, A. R., Hussey, R., and Tauchen, G. (1995). Non-parametric estimation of structural models for high frequency currency market data. Journal of Econometrics, 66:251--287.
Bansal, R. and Shaliastovich, I. (2010). A long-run risks explanation of predictability puzzles in bond and currency markets. Duke University and Wharton Business School, Working Paper.
Bekaert, G. (1996). The time-variation of risk and return in foreign exchange markets: A general equilibrium perspective. Review of Financial Studies, 9:427--470.
Bekaert, G. and Hodrick, R. J. (1993). On biases in the measurement of foreign exchange risk premiums. Journal of International Money and Finance, 12:115--138.
Bekaert, G., Hodrick, R. J., and Marshall, D. (1997). The implications of first-order risk aversion for asset market risk premiums. Journal of Monetary Economics, 40:3--39.
Benjamini, Y. and Hochberg, Y. (1995). Controlling the false discovery rate: a practical and powerful approach to multiple testing. Journal of the Royal Statistical Society B, 57:289--300.
Bibkov, R. and Chernov, M. (2011). Yield curve and volatility: Lessons from eurodollar futures and options. Journal of Financial Econometrics, 9:66--105.
Bilson, J. F. O. (1981). The speculative efficiency hypothesis. Journal of Business, 54:435--451.
Björk, T. (2004). Arbitrage Theory in Continuous Time. Oxford University Press, 2 edition.
Boudoukh, J., Richardson, M., and Whitelaw, R. (2006). The myth of long-horizon predictability. Review of Financial Studies, 21:1577--1605.
Brandt, M. W. and Santa-Clara, P. (2002). Simulated likelihood estimation of diffusions with an application to exchange rate dynamics in incomplete markets. Journal of Financial Economics, 63:161--210.
Brennan, M. and Xia, Y. (2006). International capital markets and foreign exchange risk. Review of Financial Studies, 19:753--795.
Britten-Jones, M. and Neuberger, A. (2000). Option prices, implied price processes, and stochastic volatility. The Journal of Finance, 55:839--866.
Brunnermeier, M., Nagel, S., and Pedersen, L. (2008). Carry trades and currency crashes. NBER Macroeconomics Annual, 23.
Burnside, C., Eichenbaum, M., Kleshehelski, I., and Rebelo, S. (2010). Do peso problems explain the returns to the carry trade? Review of Financial Studies. Forthcoming.
Campbell, J. Y. and Thompson, S. B. (2008). Predicting excess stock returns out of sample: Can anything beat the historical average? Review of Financial Studies, 21:1509--1531.
Carr, P. and Wu, L. (2007). Stochastic skew in currency options. Journal of Financial Economics, 86:213--247.
Cheridito, P., Filipovic, D., and Kimmel, R. (2007). Market price of risk specifications for affine models: Theory and evidence. Journal of Financial Economics, 83:123--170.
Christensen, J., Diebold, F., and Rudebusch, G. (2010). The affine arbitrage-free class of nelson-siegel term structure models. Journal of Econometrics. Forthcoming.
Clark, T. E. and West, K. D. (2007). Approximately normal tests for equal predictive accuracy in nested models. Journal of Econometrics, 138:291--311.
Cochrane, J. (2001). Asset Pricing. Princeton University Press.
Collin-Dufresne, P. and Goldstein, R. (2002). Do bonds span the fixed income markets? Theory and evidence for unspanned stochastic volatility. Journal of Finance, 57:1685--1730.
Collin-Dufresne, P., Goldstein, R. S., and Jones, C. S. (2008). Identification of maximal affine term structure models. Journal of Finance, 63:743--795.
Cuchiero, C., Teichmann, J., and Keller-Ressel, M. (2008). Polynomial processes and their application to mathematical finance. http://arxiv.org/abs/0812.4740.
Cumby, R. E. (1988). Is it risk? explaining deviations from uncovered interest parity. Journal of Monetary Economics, 22:279--299.
Dai, Q. and Singleton, K. J. (2000). Specification analysis of affine term structure models. Journal of Finance, 55:1943--1978.
De Santis, R. and Fornari, F. (2008). Does business cycle risk account for systematic returns from currency positioning? European Central Bank, Working paper.
Della Corte, P., Sarno, L., and Tsiakas, I. (2009). An economic evaluation of empirical exchange rate models. Review of Financial Studies, 22:3491--3530.
Della Corte, P., Sarno, L., and Tsiakas, I. (2011). Spot and forward volatility in foreign exchange. Journal of Financial Economics, 100:496--513.
Dewachter, H. and Maes, K. (2001). An admissible affine model for joint term structure dynamics of interest rates. KU Leuven, Working paper.
Diebold, F. X. and Mariano, R. S. (1995). Comparing predictive accuracy. Journal of Business & Economic Statistics, 13:253--263.
Diez de los Rios, A. (2009). Can affine term structure models help us predict exchange rates? Journal of Money, Credit and Banking, 41:755--766.
Domowitz, I. and Hakkio, C. (1985). Conditional variance and the risk premium in the foreign exchange market. Journal of International Economics, 19:47--66.
Duffee, G. (2002). Term premia and interest rate forecasts in affine models. Journal of Finance, 57:405--443.
Duffee, G. (2006). Term structure estimation without using latent factors. Journal of Financial Economics, 79:507--536.
Duffee, G. (2011). Information in (and not in) the term structure. Review of Financial Studies. Forthcoming.
Duffie, D., Filipovic, D., and Schachermayer, W. (2003). Affine processes and applications in finance. Annals of Applied Probability, 13:984--1053.
Engel, C. (1996). The forward discount anomaly and the risk premium: A survey of recent evidence. Journal of Empirical Finance, 3:123--192.
Engel, C. and West, K. (2005). Exchange rates and fundamentals. Journal of Political Economy, 113:485--517.
Fama, E. (1984). Forward and spot exchange rates. Journal of Monetary Economics, 14:319--338.
Farhi, E., Fraiberger, S., Gabaix, X., Ranciere, R., and Verdelhan, A. (2009). Crash risk in currency markets. Harvard University and NYU, Working Paper.
Farhi, E. and Gabaix, X. (2011). Rare disasters and exchange rates. Harvard University and NYU, Working Paper.
Feldhütter, P. and Lando, D. (2008). Decomposing swap spreads. Journal of Financial Economics, 88:375--405.
Frankel, J. and Poonawala, J. (2010). The forward market in emerging currencies: Less biased than in major currencies. Journal of International Money and Finance, 29:585--598.
Frankel, J. A. and Engel, C. (1984). Do asset demand functions optimize over the mean and variance of real returns? a six currency test. Journal of International Economics, 17:309--323.
Froot, K. A. and Thaler, R. H. (1990). Anomalies: Foreign exchange. The Journal of Economic Perspectives, 4:179--192.
Garman, M. and Kohlhagen, S. (1983). Foreign currency option values. Journal of International Money and Finance, 2:231--237.
Giacomini, R. and White, H. (2006). Tests of conditional predictive ability. Econometrica, 74:1545--1578.
Graveline, J. J. (2006). Exchange rate volatility and the forward premium anomaly. Working paper, University of Minnesota.
Hall, P., Horowitz, J., and Jing, B. (1995). On blocking rules for the bootstrap with dependent data. Biometrika, 82:561--574.
Hallin, M., Paindaveine, D., and Siman, M. (2010). Multivariate quantiles and multiple-output regression quantiles: From l1 optimization to halfspace depth. Annals of Statistics, 38:635--669.
Hammersley, J. and Clifford, P. (1970). Markov Fields on Finite Graphs and Lattices. Unpublished Manuscript.
Hansen, L. P. and Hodrick, R. J. (1980). Forward exchange rates as optimal predictors of future spot rates: An econometric analysis. Journal of Political Economy, 88:829--853.
Hodrick, R. J. (1987). The Empirical Evidence on the Efficiency of Forward and Futures Foreign Exchange Markets. Harwood Academic Publishers.
Inci, A. C. and Lu, B. (2004). Exchange rates and interest rates: Can term structure models explain currency movements? Journal of Economic Dynamics & Control, 28:1595--1624.
Jiang, G. and Tian, Y. (2005). The model-free implied volatility and its information content. Review of Financial Studies, 18:1305--1342.
Johannes, M. and Polson, N. (2009). MCMC methods for continuous-time financial econometrics. In Ait-Sahalia, Y. and Hansen, L. P., editors,Handbook of Financial Econometrics, volume 2, pages 1--72. Elsevier.
Jurek, J. W. (2009). Crash-neutral currency carry trades. Princeton University, Working Paper.
Künsch, H. (1989). The jackknife and the bootstrap for general stationary observations. Annals of Statistics, 17:1217--1241.
Leippold, M. and Wu, L. (2007). Design and estimation of multi-currency quadratic models. Review of Finance, 11:167 -- 207.
Litterman, R. and Scheinkman, J. A. (1991). Common factors affecting bond returns. Journal of Fixed Income, 1:54--61.
Lustig, H., Roussanov, N., and Verdelhan, A. (2010a). Common risk factors in currency markets. MIT, UCLA, and Wharton, Working Paper.
Lustig, H., Roussanov, N., and Verdelhan, A. (2010b). Countercyclical currency risk premia. MIT, UCLA, and Wharton, Working Paper.
Lustig, H. and Verdelhan, A. (2007). The cross-section of currency risk premia and us consumption growth risk. American Economic Review, 97:89--117.
Mark, N. C. (1988). Time varying betas and risk premia in the pricing of forward foreign exchange contracts. Journal of Financial Economics, 22:335--354.
Mele, A. (2009). Lectures on financial economics. Lecture Notes, London School of Economics.
Menkhoff, L., Sarno, L., Schmeling, M., and Schrimpf, A. (2011). Carry trades and global foreign exchange volatility. Journal of Finance. Forthcoming.
Mosburger, G. and Schneider, P. (2005). Modelling international bond markets with affine term structure models. Working paper, University of Vienna, Vienna University of Economics and Business.
Newey, W. and West, K. (1987). A simple positive semi-definite, heteroscedasticity and autocorrelation consistent covariance matrix. Econometrica, 55:703--708.
Nielsen, L. T. and Saa-Requejo, J. (1993). Exchange rate and term structure dynamics and the pricing of derivative securities. Unpublished manuscript, INSEAD.
Pan, J. (2002). The jump-risk premia implicit in options: Evidence from an integrated time-series study. Journal of Financial Economics, 63:3--50.
Patton, A., Politis, D., and White, H. (2009). Correction to ``automatic block-length selection for dependent bootstrap''. Econometric Reviews, 28:372--375.
Pesaran, M. H. and Timmermann, A. (1992). A simple nonparametric test of predictive performance. Journal of Business & Economic Statistics, 10(4):461--465.
Politis, D. and White, H. (2004). Automatic block-length selection for dependent bootstrap. Econometric Reviews, 23(1):53--70.
Saa-Requejo, J. (1994). The dynamics and the term structure of risk premia in foreign exchange markets. Unpublished manuscript, INSEAD.
Serfling, R. (2002). Quantile functions for multivariate analysis: Approaches and applications. Statistica Neerlandica, 56:214--232.
Verdelhan, A. (2010). A habit-based explanation of the exchange rate risk premium. Journal of Finance, 65(1):143--145.
Available Versions of this Item
Properties of Foreign Exchange Risk Premia. (deposited 13. Mar 2010 10:58)
Properties of Foreign Exchange Risk Premiums. (deposited 23. Oct 2010 00:24)
- Properties of Foreign Exchange Risk Premiums. (deposited 27. Apr 2011 09:49) [Currently Displayed]
- Properties of Foreign Exchange Risk Premiums. (deposited 23. Oct 2010 00:24)