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Asset prices with stochastic volatilities and a UIP puzzle

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  • Lee, Eunhee

Abstract

In this paper, I extend the two-country general equilibrium model with smooth transition regimes in volatilities to examine the time-varying features of foreign exchange excess returns. The representative agent is assumed to have the Epstein-Zin-Weil preference, which allows the long run risks and macroeconomic uncertainties to be priced. The smooth transition in volatilities generates another route of uncertainty in macroeconomic variabilities for each country, which plays an important role in determining the behavior of changes in exchange rates and interest differentials across countries. Furthermore, I present an explanation for the failure of the uncovered interest parity condition, showing that the expected excess returns can be negatively correlated with the interest differential in the model. The results of the simulation show that if the representative agent with the Epstein-Zin-Weil utility prefers early resolution of uncertainty, the uncovered interest parity puzzle can be explained.

Suggested Citation

  • Lee, Eunhee, 2019. "Asset prices with stochastic volatilities and a UIP puzzle," International Review of Economics & Finance, Elsevier, vol. 64(C), pages 41-61.
    • Handle: RePEc:eee:reveco:v:64:y:2019:i:c:p:41-61
    DOI: 10.1016/j.iref.2019.05.004
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    More about this item

    Keywords

    Uncovered interest parity puzzle; Risk premium in currency market; Macroeconomic uncertainty; Stochastic volatility model; Smooth transition; Consumption based asset pricing model;
    All these keywords.

    JEL classification:

    • C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth

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