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An arbitrage-free Nelson-Siegel term structure model with stochastic volatility for the determination of currency risk premia

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  • S. Mouabbi

Abstract

This paper uses a risk-averse formulation of the uncovered interest rate parity to determine exchange rates through interest rate differentials, and ultimately extract currency risk premia. The method proposed consists of developing an affine Arbitrage-Free class of dynamic Nelson-Siegel term structure models with stochastic volatility to obtain the domestic and foreign discount rate variations, which in turn are used to derive a representation of exchange rate depreciations. No-arbitrage restrictions allow to endogenously capturing currency risk premia. Empirical findings suggest that estimated currency risk premia are able to account for the forward premium puzzle and their properties are examined.

Suggested Citation

  • S. Mouabbi, 2014. "An arbitrage-free Nelson-Siegel term structure model with stochastic volatility for the determination of currency risk premia," Working papers 527, Banque de France.
    • Handle: RePEc:bfr:banfra:527
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    More about this item

    Keywords

    term structure of interest rates; affine; exchange rates; risk premia.;
    All these keywords.

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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