Affine term structure models for the foreign exchange risk premium

Luca Benati ()

Bank of England working papers from Bank of England

Abstract: This paper uses two affine term structure models from the Duffie-Kan class - a three-factor Cox-Ingersoll-Ross model, and a three-factor model in the spirit of Longstaff and Schwartz - to extract historical estimates of foreign exchange risk premia for the pound with respect to the US dollar. The term structures of interest rates for the two countries are estimated jointly, together with the dynamics of the nominal exchange rates between them, via maximum likelihood. The likelihood function is computed via the Kalman filter, and is maximised numerically with respect to unknown parameters. Particular attention is paid to the robustness of the results across models; to the overall (filter plus parameter) econometric uncertainty associated with risk premia estimates; and to the ability of estimated structures to replicate Fama's 'forward discount anomaly'. The paper's main results may be summarised as follows. First, risk premia estimates are not consistent across the two models. Second, both models fail to replicate the forward discount anomaly, with theoretical values of ? in the Fama regressions implied by estimated structures being consistently positive at all horizons from 1 to 12 months.

Date: 2006-03
New Economics Papers: this item is included in nep-fmk and nep-ifn
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (4)

Downloads: (external link)
http://www.bankofengland.co.uk/research/Documents/workingpapers/2006/WP291.pdf (application/pdf)
Our link check indicates that this URL is bad, the error code is: 404 Not Found (http://www.bankofengland.co.uk/research/Documents/workingpapers/2006/WP291.pdf [301 Moved Permanently]--> https://www.bankofengland.co.uk/research/Documents/workingpapers/2006/WP291.pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:boe:boeewp:291

Access Statistics for this paper

More papers in Bank of England working papers from Bank of England Bank of England, Threadneedle Street, London, EC2R 8AH. Contact information at EDIRC.
Bibliographic data for series maintained by Digital Media Team ().