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Affine Models of Currency Pricing

Authors: David, Backus
Foresi, Silverio
Telmer, Chris
Keywords: forward and spot exchange rates;risk premiums;pricing kernels
Issue Date: 16-Apr-1996
Series/Report no.: FIN-96-009
Abstract: Perhaps the most puzzling feature of currency prices is the tendency for high interest rate currencies to appreciate when the expectations hypothesis suggests the reverse. Some have attributed this forward premium anomaly to a time-varying risk premium but theory has been largely unsuccessful in producing a risk premium with the requisite properties. We characterize the risk premium in a general arbitrage-free setting and describe the features a theory must have to account for the anomaly. In affine models the anomaly requires either that state variables have asymmetric effects on state prices in different currencies or that we abandon the common requirement that interest rates be strictly positive.
Appears in Collections:Finance Working Papers

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