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Quadratic term structure models with jumps in incomplete currency markets

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  • Daal, Elton

    (University of New Orleans)

Abstract

We propose a multi-currency quadratic term structure model that allows for several sources of market incompleteness. A new feature of the model is the jump-quadratic dynamics of the exchange rates that simultaneously generate greater flexibility in the time-varying risk premium and excessive currency volatility. Our model empirically outperforms the complete market quadratic and affine multi-currency diffusion models. It accounts for the forward premium anomaly with reasonable market price of risks. The market incompleteness consists of idiosyncratic diffusion-like innovations and jump discontinuities. We find that the jumps dominate the variations in the currency returns and produce most of the excessive currency volatility.

Suggested Citation

  • Daal, Elton, 2004. "Quadratic term structure models with jumps in incomplete currency markets," Working Papers 2004-04, University of New Orleans, Department of Economics and Finance.
    • Handle: RePEc:uno:wpaper:2004-04
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    More about this item

    Keywords

    Quadratic term structure; Incomplete markets; Jumps; Excess volatility;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
    • C14 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Semiparametric and Nonparametric Methods: General

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