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Empirical Test of Affine Stochastic Discount Factor Model of Currency Pricing

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Author Info
Alex Lebedinsky () (Western Kentucky University)
Abstract

In this note, I conduct an empirical investigation of the affine stochastic discount factor model proposed by Backus, Foresi and Telmer (2001), who showed that such a model might be able to explain the forward premium anomaly. Evidence presented here suggests that the model can reproduce the forward premium anomaly only by placing restrictions on the behavior of spot and forward exchange rates that are not consistent with the data. The model assumes that an increase in the forward premium must be accompanied by an increase in volatilities of the forward premium and of the exchange rate depreciation. I find that this assumption is not supported by the data. When I relax the model by allowing the forward premium to vary without necessarily affecting conditional second moments, the model no longer reproduces the forward premium anomaly. Thus, I conclude that the model can reproduce the anomaly only by forcing a linear heteroskedastic process that is not supported by the data.

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File URL: http://economicsbulletin.vanderbilt.edu/2008/volume6/EB-08F30012A.pdf
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Article provided by Economics Bulletin in its journal Economics Bulletin.

Volume (Year): 6 (2008)
Issue (Month): 15 ()
Pages: 1-14
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Handle: RePEc:ebl:ecbull:v:6:y:2008:i:15:p:1-14

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Related research
Keywords: forward premium anomaly; stochastic discount factor; affine; exchange rates;

Find related papers by JEL classification:
F3 - International Economics - - International Finance
G0 - Financial Economics - - General

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  1. David K. Backus, 2001. "Affine Term Structure Models and the Forward Premium Anomaly," Journal of Finance, American Finance Association, vol. 56(1), pages 279-304, 02. [Downloadable!] (restricted)
  2. Bekaert, Geert & Hodrick, Robert J., 1993. "On biases in the measurement of foreign exchange risk premiums," Journal of International Money and Finance, Elsevier, vol. 12(2), pages 115-138, April. [Downloadable!] (restricted)
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  3. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "A Theory of the Term Structure of Interest Rates," Econometrica, Econometric Society, vol. 53(2), pages 385-407, March. [Downloadable!] (restricted)
  4. Bansal, Ravi, 1997. "An Exploration of the Forward Premium Puzzle in Currency Markets," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 10(2), pages 369-403.
  5. Dong-Hyun Ahn & Robert F. Dittmar, 2002. "Quadratic Term Structure Models: Theory and Evidence," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 15(1), pages 243-288, March.
  6. Engel, Charles, 1996. "The forward discount anomaly and the risk premium: A survey of recent evidence," Journal of Empirical Finance, Elsevier, vol. 3(2), pages 123-192, June. [Downloadable!] (restricted)
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  7. Fama, Eugene F., 1984. "Forward and spot exchange rates," Journal of Monetary Economics, Elsevier, vol. 14(3), pages 319-338, November. [Downloadable!] (restricted)
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