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International Capital Markets and Foreign Exchange Risk

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  • Brennan, Michael J.
  • Xia, Yihong
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    Abstract

    The relation between the volatilities of pricing kernels associated with di�erent currencies and the volatility of the exchange rate between the currencies is derived under the assumption of integrated capital markets, and the volatilities of the pricing kernels are related to the foreign exchange risk premium. Time series of pricing kernel volatilities are estimated from panel data on bond yields for five major currencies using a parsimonious term structure model that allows for time varying pricing kernel volatilities. The resulting estimates are used to test hypotheses about the relation between the volatilities of the pricing kernels in di�erent currencies and the volatility of the exchange rate. As predicted, time variation in foreign exchange risk premia is found to be related to time variation in both the volatility of the pricing kernels and the volatility of exchange rates: the estimated pricing kernel volatilities can account for the forward premium puzzle in an ‘average’ sense across exchange rates.

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    Bibliographic Info

    Paper provided by Anderson Graduate School of Management, UCLA in its series University of California at Los Angeles, Anderson Graduate School of Management with number qt53z0s29k.

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    Date of creation: 22 Jan 2004
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    Handle: RePEc:cdl:anderf:qt53z0s29k

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    1. Geert Bekaert & Robert J. Hodrick, 1991. "Characterizing Predictable Components in Excess Returns on Equity and Foreign Exchange Markets," NBER Working Papers 3790, National Bureau of Economic Research, Inc.
    2. Bansal, Ravi, 1997. "An Exploration of the Forward Premium Puzzle in Currency Markets," Review of Financial Studies, Society for Financial Studies, vol. 10(2), pages 369-403.
    3. Ilmanen, Antti, 1995. " Time-Varying Expected Returns in International Bond Markets," Journal of Finance, American Finance Association, vol. 50(2), pages 481-506, June.
    4. 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.
    5. Baillie, Richard T & Bollerslev, Tim, 2002. "The Message in Daily Exchange Rates: A Conditional-Variance Tale," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(1), pages 60-68, January.
    6. Brennan, Michael & Wang, Ashley W & Xia, Yihong, 2003. "Estimation and Test of a Simple Model of Intertemporal Capital Asset Pricing," University of California at Los Angeles, Anderson Graduate School of Management qt20r0j5t8, Anderson Graduate School of Management, UCLA.
    7. Fama, Eugene F & Bliss, Robert R, 1987. "The Information in Long-Maturity Forward Rates," American Economic Review, American Economic Association, vol. 77(4), pages 680-92, September.
    8. Lewis, Karen K., 1995. "Puzzles in international financial markets," Handbook of International Economics, in: G. M. Grossman & K. Rogoff (ed.), Handbook of International Economics, edition 1, volume 3, chapter 37, pages 1913-1971 Elsevier.
    9. Geert Bekaert, 1994. "The Time Variation of Risk and Return in Foreign Exchange Markets: A General Equilibrium Perspective," NBER Working Papers 4818, National Bureau of Economic Research, Inc.
    10. Robert R. Bliss, 1996. "Testing term structure estimation methods," Working Paper 96-12, Federal Reserve Bank of Atlanta.
    11. Jorion, Philippe, 1995. " Predicting Volatility in the Foreign Exchange Market," Journal of Finance, American Finance Association, vol. 50(2), pages 507-28, June.
    12. Fama, Eugene F & French, Kenneth R, 1987. "Commodity Futures Prices: Some Evidence on Forecast Power, Premiums,and the Theory of Storage," The Journal of Business, University of Chicago Press, vol. 60(1), pages 55-73, January.
    13. 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.
    14. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
    15. Frankel, Jeff & Froot, Ken, 1986. "Using Survey Data to Test Standard Propositions Regarding Exchange Rate Expectations," Department of Economics, Working Paper Series qt1972q8wm, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
    16. 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.
    17. Huang, Chi-Fu, 1985. "Information structure and equilibrium asset prices," Journal of Economic Theory, Elsevier, vol. 35(1), pages 33-71, February.
    18. 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.
    19. Qiang Dai & Kenneth Singleton, 2003. "Term Structure Dynamics in Theory and Reality," Review of Financial Studies, Society for Financial Studies, vol. 16(3), pages 631-678, July.
    20. Richard Roll & Shu Yan, 2000. "An explanation of the forward premium 'puzzle'," European Financial Management, European Financial Management Association, vol. 6(2), pages 121-148.
    21. Jeffrey A. Frankel & Kenneth A. Froot, 1985. "Using Survey Data to Test Some Standard Propositions Regarding Exchange Rate Expectations," NBER Working Papers 1672, National Bureau of Economic Research, Inc.
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    Cited by:
    1. Georg Mosburger & Paul Schneider, 2005. "Modelling International Bond Markets with Affine Term Structure Models," Finance 0509003, EconWPA.
    2. Antonio Diez De Los Rios, 2009. "Can Affine Term Structure Models Help Us Predict Exchange Rates?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 41(4), pages 755-766, 06.
    3. Margarida Duarte & Alan C. Stockman, 2001. "Rational Speculation and Exchange Rates," NBER Working Papers 8362, National Bureau of Economic Research, Inc.
    4. Brennan, Michael J, 2004. "How Did It Happen?," University of California at Los Angeles, Anderson Graduate School of Management qt1047x6kv, Anderson Graduate School of Management, UCLA.

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