Quadratic term structure models with jumps in incomplete currency markets
AbstractWe 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.
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Bibliographic InfoPaper provided by University of New Orleans, Department of Economics and Finance in its series Working Papers with number 2004-04.
Length: 53 pages
Date of creation: 29 Sep 2004
Date of revision:
Quadratic term structure; Incomplete markets; Jumps; Excess volatility;
Find related papers by 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
This paper has been announced in the following NEP Reports:
- NEP-ALL-2005-04-03 (All new papers)
- NEP-FMK-2005-04-03 (Financial Markets)
- NEP-IFN-2005-04-03 (International Finance)
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