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Exchange rate risks and asset prices in a small open economy

  • Derviz, Alexis

The paper proposes a multi-factor international asset pricing model in which the exchange rate is allowed to be co-determined by a risk factor imperfectly correlated to other priced risks in the economy. The significance of this factor can be established as long as one is able to observe a proxy for the foreign cash order flow. Then, the asset pricing model is decomposed into the standard ICCAPM no-arbitrage setup characterized by a pricing kernel, in which, however, the “autarky” exchange rate is unobserved, and an additional equation that links this autarchic currency price with the FX order flow. The model is put in the state space form. The unobserved variables span the macroeconomic risk factors with an impact on the asset markets and determine the dynamics of the pricing kernel, the autarchic exchange rate and the FX order flow. A comparison of models allowing for an independent OF risk factor with a restricted one, where the forex order flow plays no role, should disclose the existence of a “nonfundamental” source of a systematic divergence of the observed and the autarchic (i.e. fundamental) FX returns. The model is calibrated and tested on the Czech koruna/euro exchange rate in a setting with seven Czech and euro area asset returns. JEL Classification: F31, F41, G12, G15

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Paper provided by European Central Bank in its series Working Paper Series with number 0314.

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Date of creation: Mar 2004
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Handle: RePEc:ecb:ecbwps:20040314
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  1. Darrell Duffie & Rui Kan, 1996. "A Yield-Factor Model Of Interest Rates," Mathematical Finance, Wiley Blackwell, vol. 6(4), pages 379-406.
  2. Alexis Derviz, 2002. "The uncovered parity properties of the czech koruna," Prague Economic Papers, University of Economics, Prague, vol. 2002(1).
  3. Andrew Ang & Monika Piazzesi, 2001. "A No-Arbitrage Vector Autoregression of Term Structure Dynamics with Macroeconomic and Latent Variables," NBER Working Papers 8363, National Bureau of Economic Research, Inc.
  4. Derviz, Alexis, 2004. "Asset return dynamics and the FX risk premium in a decentralized dealer market," European Economic Review, Elsevier, vol. 48(4), pages 747-784, August.
  5. Ait-Sahalia, Yacine & Lo, Andrew W., 2000. "Nonparametric risk management and implied risk aversion," Journal of Econometrics, Elsevier, vol. 94(1-2), pages 9-51.
  6. Antulio N. Bomfim, 2003. "Monetary policy and the yield curve," Finance and Economics Discussion Series 2003-15, Board of Governors of the Federal Reserve System (U.S.).
  7. Alexis Derviz, 2003. "Components of the Czech Koruna Risk Premium in a Multiple-Dealer FX Market," Working Papers 2003/04, Czech National Bank, Research Department.
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