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Quadratic term structure models with jumps in incomplete currency markets

Elton Daal
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Elton Daal: University of New Orleans

No 2004-04, Working Papers from University of New Orleans, Department of Economics and Finance

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.

Keywords: Quadratic term structure; Incomplete markets; Jumps; Excess volatility (search for similar items in EconPapers)
JEL-codes: F31 E43 D52 C14 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-fmk and nep-ifn
Date: 2004-09-29
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