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Currency Risk and Pricing Kernel Volatility

Chris Telmer (), Batchimeg Sambalaibat and Federico Gavazzoni ()
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Batchimeg Sambalaibat: Carnegie Mellon University

No 558, 2012 Meeting Papers from Society for Economic Dynamics

Abstract: A basic tenet of lognormal asset pricing models is that a risky currency is associated with a low pricing kernel volatility. Empirical evidence implies that a risky currency is associated with a relatively high interest rate. Taken together, these two statements associate high-interest-rate currencies with low pricing kernel volatility. We document evidence suggesting that the opposite is true. We approximate the volatility of the pricing kernel with the volatility of the short interest rate. We find that, across currencies, relatively high interest rate volatility is associated with relatively high interest rates. This contradicts the prediction of lognormal models. One possible reason is that our approximation of the volatility of the pricing kernel is inadequate. We argue that this is unlikely, in particular for questions involving currencies. We conclude that lognormal models of the pricing kernel are inadequate for explaining currency risk and that future work should place increased emphasis on higher moments.

Date: 2012
New Economics Papers: this item is included in nep-mst and nep-opm
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