Advanced Search
MyIDEAS: Login to save this paper or follow this series

Affine term structure models for the foreign exchange risk premium

Contents:

Author Info

  • Luca Benati

Abstract

This paper uses two affine term structure models from the Duffie-Kan class - a three-factor Cox-Ingersoll-Ross model, and a three-factor model in the spirit of Longstaff and Schwartz - to extract historical estimates of foreign exchange risk premia for the pound with respect to the US dollar. The term structures of interest rates for the two countries are estimated jointly, together with the dynamics of the nominal exchange rates between them, via maximum likelihood. The likelihood function is computed via the Kalman filter, and is maximised numerically with respect to unknown parameters. Particular attention is paid to the robustness of the results across models; to the overall (filter plus parameter) econometric uncertainty associated with risk premia estimates; and to the ability of estimated structures to replicate Fama's 'forward discount anomaly'. The paper's main results may be summarised as follows. First, risk premia estimates are not consistent across the two models. Second, both models fail to replicate the forward discount anomaly, with theoretical values of ? in the Fama regressions implied by estimated structures being consistently positive at all horizons from 1 to 12 months.

Download Info

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
File URL: http://www.bankofengland.co.uk/research/Documents/workingpapers/2006/WP291.pdf
Download Restriction: no

Bibliographic Info

Paper provided by Bank of England in its series Bank of England working papers with number 291.

as in new window
Length:
Date of creation: Mar 2006
Date of revision:
Handle: RePEc:boe:boeewp:291

Contact details of provider:
Postal: Publications Group Bank of England Threadneedle Street London EC2R 8AH
Phone: +44 (0)171 601 4030
Fax: +44 (0)171 601 5196
Email:
Web page: http://www.bankofengland.co.uk/
More information through EDIRC

Related research

Keywords:

This paper has been announced in the following NEP Reports:

References

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
as in new window
  1. Nicola Anderson & John Sleath, 2001. "New estimates of the UK real and nominal yield curves," Bank of England working papers 126, Bank of England.
  2. Hodrick, Robert & Vassalou, Maria, 2002. "Do we need multi-country models to explain exchange rate and interest rate and bond return dynamics?," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 26(7-8), pages 1275-1299, July.
  3. Backus, David K & Gregory, Allan W & Telmer, Chris I, 1993. " Accounting for Forward Rates in Markets for Foreign Currency," Journal of Finance, American Finance Association, American Finance Association, vol. 48(5), pages 1887-1908, December.
  4. Michael J. Brennan and Eduardo S. Schwartz., 1979. "A Continuous-Time Approach to the Pricing of Bonds," Research Program in Finance Working Papers, University of California at Berkeley 85, University of California at Berkeley.
  5. Geert Bekaert & Robert J. Hodrick, 1991. "On Biases in the Measurement of Foreign Exchange Risk Premiums," NBER Working Papers 3861, National Bureau of Economic Research, Inc.
  6. Domowitz, Ian & Hakkio, Craig S., 1985. "Conditional variance and the risk premium in the foreign exchange market," Journal of International Economics, Elsevier, vol. 19(1-2), pages 47-66, August.
  7. David Backus & Silverio Foresi & Chris Telmer, 1996. "Affine Models of Currency Pricing," New York University, Leonard N. Stern School Finance Department Working Paper Seires, New York University, Leonard N. Stern School of Business- 96-9, New York University, Leonard N. Stern School of Business-.
  8. Fama, Eugene F., 1984. "Forward and spot exchange rates," Journal of Monetary Economics, Elsevier, Elsevier, vol. 14(3), pages 319-338, November.
  9. Qiang Dai & Kenneth J. Singleton, 2000. "Specification Analysis of Affine Term Structure Models," Journal of Finance, American Finance Association, American Finance Association, vol. 55(5), pages 1943-1978, October.
  10. Ang, Andrew & Piazzesi, Monika, 2003. "A no-arbitrage vector autoregression of term structure dynamics with macroeconomic and latent variables," Journal of Monetary Economics, Elsevier, Elsevier, vol. 50(4), pages 745-787, May.
  11. Brandt, Michael W. & Santa-Clara, Pedro, 2002. "Simulated likelihood estimation of diffusions with an application to exchange rate dynamics in incomplete markets," Journal of Financial Economics, Elsevier, Elsevier, vol. 63(2), pages 161-210, February.
  12. Robert J. Hodrick, 1988. "U.S. International Capital Flows: Perspectives From Rational Maximizing Models," NBER Working Papers 2729, National Bureau of Economic Research, Inc.
  13. Pearson, Neil D & Sun, Tong-Sheng, 1994. " Exploiting the Conditional Density in Estimating the Term Structure: An Application to the Cox, Ingersoll, and Ross Model," Journal of Finance, American Finance Association, American Finance Association, vol. 49(4), pages 1279-1304, September.
  14. de Jong, Frank & Santa-Clara, Pedro, 1999. "The Dynamics of the Forward Interest Rate Curve: A Formulation with State Variables," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 34(01), pages 131-157, March.
  15. de Jong, Frank, 2000. "Time Series and Cross-Section Information in Affine Term-Structure Models," Journal of Business & Economic Statistics, American Statistical Association, American Statistical Association, vol. 18(3), pages 300-314, July.
  16. David K. Backus, 2001. "Affine Term Structure Models and the Forward Premium Anomaly," Journal of Finance, American Finance Association, American Finance Association, vol. 56(1), pages 279-304, 02.
  17. Hamilton, James D., 1986. "A standard error for the estimated state vector of a state-space model," Journal of Econometrics, Elsevier, Elsevier, vol. 33(3), pages 387-397, December.
  18. Groen, Jan J.J. & Balakrishnan, Ravi, 2006. "Asset price based estimates of sterling exchange rate risk premia," Journal of International Money and Finance, Elsevier, Elsevier, vol. 25(1), pages 71-92, February.
  19. Engel, Charles, 1996. "The forward discount anomaly and the risk premium: A survey of recent evidence," Journal of Empirical Finance, Elsevier, Elsevier, vol. 3(2), pages 123-192, June.
  20. Brennan, Michael J. & Schwartz, Eduardo S., 1979. "A continuous time approach to the pricing of bonds," Journal of Banking & Finance, Elsevier, vol. 3(2), pages 133-155, July.
  21. Markus Leippold & Liuren Wu, 2002. "Asset Pricing Under The Quadratic Class," Finance, EconWPA 0207015, EconWPA.
  22. Taylor, Mark P, 1988. "A DYMIMIC Model of Forward Foreign Exchange Risk, with Estimates for Three Major Exchange Rates," The Manchester School of Economic & Social Studies, University of Manchester, University of Manchester, vol. 56(1), pages 55-68, March.
  23. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "A Theory of the Term Structure of Interest Rates," Econometrica, Econometric Society, Econometric Society, vol. 53(2), pages 385-407, March.
  24. Lewis, K.K., 1994. "Puzzles in international Financial Markets," Weiss Center Working Papers, Wharton School - Weiss Center for International Financial Research 94-7, Wharton School - Weiss Center for International Financial Research.
  25. Lucas, Robert Jr., 1982. "Interest rates and currency prices in a two-country world," Journal of Monetary Economics, Elsevier, Elsevier, vol. 10(3), pages 335-359.
  26. David K. Backus & Stanley E. Zin, 1994. "Reverse Engineering the Yield Curve," NBER Working Papers 4676, National Bureau of Economic Research, Inc.
  27. David K. Backus & Chris I. Telmer & Liuren Wu, 1999. "Design and Estimation of Affine Yield Models," GSIA Working Papers, Carnegie Mellon University, Tepper School of Business 5, Carnegie Mellon University, Tepper School of Business.
  28. Watson, Mark W. & Engle, Robert F., 1983. "Alternative algorithms for the estimation of dynamic factor, mimic and varying coefficient regression models," Journal of Econometrics, Elsevier, Elsevier, vol. 23(3), pages 385-400, December.
  29. E.K. Berndt & B.H. Hall & R.E. Hall, 1974. "Estimation and Inference in Nonlinear Structural Models," NBER Chapters, in: Annals of Economic and Social Measurement, Volume 3, number 4, pages 103-116 National Bureau of Economic Research, Inc.
  30. Hai, Weike & Mark, Nelson C & Wu, Yangru, 1997. "Understanding Spot and Forward Exchange Rate Regressions," Journal of Applied Econometrics, John Wiley & Sons, Ltd., John Wiley & Sons, Ltd., vol. 12(6), pages 715-34, Nov.-Dec..
  31. Modjtahedi, Bagher, 1991. "Multiple maturities and time-varying risk premia in forward exchange markets : An econometric analysis," Journal of International Economics, Elsevier, vol. 30(1-2), pages 69-86, February.
  32. David Backus & Silverio Foresi & Chris Telmer, 1998. "Discrete-Time Models of Bond Pricing," NBER Working Papers 6736, National Bureau of Economic Research, Inc.
  33. Canova, Fabio & Ito, Takatoshi, 1991. "The Time-Series Properties of the Risk Premium in the Yen/Dollar Exchange Market," Journal of Applied Econometrics, John Wiley & Sons, Ltd., John Wiley & Sons, Ltd., vol. 6(2), pages 125-42, April-Jun.
  34. Harvey, Andrew & Ruiz, Esther & Sentana, Enrique, 1992. "Unobserved component time series models with Arch disturbances," Journal of Econometrics, Elsevier, Elsevier, vol. 52(1-2), pages 129-157.
  35. Karen K. Lewis, 1994. "Puzzles in International Financial Markets," NBER Working Papers 4951, National Bureau of Economic Research, Inc.
Full references (including those not matched with items on IDEAS)

Citations

Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
as in new window

Cited by:
  1. Evžen Koèenda & Tigran Poghosyan, 2010. "Exchange Rate Risk in Central European Countries," Czech Journal of Economics and Finance (Finance a uver), Charles University Prague, Faculty of Social Sciences, Charles University Prague, Faculty of Social Sciences, vol. 60(1), pages 22-39, February.
  2. Carmen Gloria Silva, 2010. "Forward premium puzzle and term structure of interest rates: the case of New Zealand," Working Papers Central Bank of Chile, Central Bank of Chile 570, Central Bank of Chile.

Lists

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

Statistics

Access and download statistics

Corrections

When requesting a correction, please mention this item's handle: RePEc:boe:boeewp:291. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Publications Team).

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.