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Affine Models of Currency Pricing

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  • David Backus
  • Silverio Foresi
  • Chris Telmer

Abstract

Perhaps the most puzzling feature of currency prices is the tendency for high interest rate currencies to appreciate, when the expectations hypothesis suggests the reverse. Some have attributed this forward premium anomaly to a time-varying risk premium, but theory has been largely unsuccessful in producing a risk premium with the requisite properties. We characterize the risk premium in a general arbitrage-free setting and describe the features a theory must have to account for the anomaly. In affine models, the anomaly requires either that state variables have asymmetric effects on state prices in different currencies or that we abandon the common requirement that interest rates be strictly positive.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 5623.

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Date of creation: Jun 1996
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Publication status: published as Journal of Finance, Volume 56: Issue 1 February 2001
Handle: RePEc:nbr:nberwo:5623

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  1. Amin, Kaushik I. & Jarrow, Robert A., 1991. "Pricing foreign currency options under stochastic interest rates," Journal of International Money and Finance, Elsevier, Elsevier, vol. 10(3), pages 310-329, September.
  2. Flood, Robert P & Rose, Andrew K, 1996. "Fixes: Of the Forward Discount Puzzle," The Review of Economics and Statistics, MIT Press, vol. 78(4), pages 748-52, November.
  3. Lars Peter Hansen & Ravi Jagannathan, 1990. "Implications of Security Market Data for Models of Dynamic Economies," NBER Technical Working Papers 0089, National Bureau of Economic Research, Inc.
  4. Bekaert, Geert, 1995. "The Time Variation of Expected Returns and Volatility in Foreign-Exchange Markets," Journal of Business & Economic Statistics, American Statistical Association, American Statistical Association, vol. 13(4), pages 397-408, October.
  5. Bekaert, Geert & Hodrick, Robert J. & Marshall, David A., 1997. "The implications of first-order risk aversion for asset market risk premiums," Journal of Monetary Economics, Elsevier, Elsevier, vol. 40(1), pages 3-39, September.
  6. 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.
  7. Mark, Nelson C., 1988. "Time-varying betas and risk premia in the pricing of forward foreign exchange contracts," Journal of Financial Economics, Elsevier, Elsevier, vol. 22(2), pages 335-354, December.
  8. Frankel, Jeffrey & Engel, Charles M., 1984. "Do asset-demand functions optimize over the mean and variance of real returns? A six-currency test," Journal of International Economics, Elsevier, Elsevier, vol. 17(3-4), pages 309-323, November.
  9. Gurdip S. Bakshi & Zhiwu Chen, . "Equilibrium Valuation of Foreign Exchange Claims," Research in Financial Economics, Ohio State University 9510, Ohio State University.
  10. Fama, Eugene F., 1984. "Forward and spot exchange rates," Journal of Monetary Economics, Elsevier, Elsevier, vol. 14(3), pages 319-338, November.
  11. Canova, Fabio & Marrinan, Jane, 1995. "Predicting excess returns in financial markets," European Economic Review, Elsevier, Elsevier, vol. 39(1), pages 35-69, January.
  12. David K. Backus & Stanley E. Zin, 1994. "Reverse Engineering the Yield Curve," Working Papers, New York University, Leonard N. Stern School of Business, Department of Economics 94-09, New York University, Leonard N. Stern School of Business, Department of Economics.
  13. Cumby, Robert E., 1988. "Is it risk? : Explaining deviations from uncovered interest parity," Journal of Monetary Economics, Elsevier, Elsevier, vol. 22(2), pages 279-299, September.
  14. Bossaerts, Peter & Hillion, Pierre, 1991. "Market Microstructure Effects of Government Intervention in the Foreign Exchange Market," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 4(3), pages 513-41.
  15. Domowitz, Ian & Hakkio, Craig S., 1985. "Conditional variance and the risk premium in the foreign exchange market," Journal of International Economics, Elsevier, Elsevier, vol. 19(1-2), pages 47-66, August.
  16. Engel, Charles & Hamilton, James D, 1990. "Long Swings in the Dollar: Are They in the Data and Do Markets Know It?," American Economic Review, American Economic Association, American Economic Association, vol. 80(4), pages 689-713, September.
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