A Latent Factor Model of European Exchange Rate Risk Premia
AbstractThe floating of a number of European currencies in 1992-93 created a new body of data on risk premia on floating exchange rates. In this paper, excess returns to investments in SEK, NOK, FIM, GBP, ITL and EPT against the DEM are investigated. We model the risk premia as functions of time varying second moments. First, univariate GARCH-M models are estimated for each currency. It turns out that excess returns are significantly higher in times of higher conditional variance for five of the six currencies investigated. Then a latent factor GARCH model that takes common effects in the different currency markets into account is applied. We use a Kalman filter to identify the unobservable risk factors and find evidence of risk premia in the sense that expected excess returns are higher in times of high conditional volatility of the factors. Expanding the model from one to two unobservable risk factors dies not improve the fit significantly. While the average magnitude of the risk premia is o.1-0.4 percentage points per year, they may reach 4-5 percentage points in times of high risk.
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Bibliographic InfoPaper provided by Stockholm School of Economics in its series Working Paper Series in Economics and Finance with number 156.
Length: 25 pages
Date of creation: Jan 1997
Date of revision:
Publication status: Forthcoming in International Journal of Finance and Economics.
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Exchange rate risk premia; latent factor models;
Other versions of this item:
- Alexius, Annika & Sellin, Peter, 1999. "A Latent Factor Model of European Exchange Rate Risk Premia," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 4(3), pages 217-27, July.
- E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
- F31 - International Economics - - International Finance - - - Foreign Exchange
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
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- Chang, Kook-Hyun & Kim, Myung-Jig, 2001. "Jumps and time-varying correlations in daily foreign exchange rates," Journal of International Money and Finance, Elsevier, vol. 20(5), pages 611-637, October.
- Herrmann, Sabine & Jochem, Axel, 2003. "Die internationale Intregration der Devisenmärkte in den mittel- und osteuropäischen Beitrittsländern: Spekulative Effizienz, Transaktionskosten und Wechselkursprämien," Discussion Paper Series 1: Economic Studies 2003,08, Deutsche Bundesbank, Research Centre.
- Alexius, Annika, 2002. "Can Endogenous Monetary Policy Explain the Deviations from UIP," Working Paper Series 2002:17, Uppsala University, Department of Economics.
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