A latent factor model of European exchange rate risk premia
✍ Scribed by Annika Alexius; Peter Sellin
- Publisher
- John Wiley and Sons
- Year
- 1999
- Tongue
- English
- Weight
- 157 KB
- Volume
- 4
- Category
- Article
- ISSN
- 1076-9307
No coin nor oath required. For personal study only.
✦ Synopsis
The floating of a number of European currencies in 1992 -1993 created a new body of data on foreign exchange risk premia, or deviations from uncovered interest rate parity (UIP). In this paper, excess returns to investments in SEK, NOK, FIM, GBP, ITL and ESP against the DEM are investigated. First, univariate GARCH-M models are estimated for each currency and UIP is tested. UIP fares as badly on this data set as in most other studies. Then a latent factor GARCH model that takes common effects in the different currency markets into account is applied. The risk premia are modelled as functions of time varying factor variances. A Kalman filter is used to identify the unobservable risk factors. A one-factor model that allows for idiosyncratic risk seem to fit the data quite well. However, the puzzling finding is made that the factor risk does not appear to be priced.