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International Capital Markets and Foreign Exchange Risk

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  • Brennan, Michael J.
  • Xia, Yihong

Abstract

The relation between the volatilities of pricing kernels associated with di�erent currencies and the volatility of the exchange rate between the currencies is derived under the assumption of integrated capital markets, and the volatilities of the pricing kernels are related to the foreign exchange risk premium. Time series of pricing kernel volatilities are estimated from panel data on bond yields for five major currencies using a parsimonious term structure model that allows for time varying pricing kernel volatilities. The resulting estimates are used to test hypotheses about the relation between the volatilities of the pricing kernels in di�erent currencies and the volatility of the exchange rate. As predicted, time variation in foreign exchange risk premia is found to be related to time variation in both the volatility of the pricing kernels and the volatility of exchange rates: the estimated pricing kernel volatilities can account for the forward premium puzzle in an ‘average’ sense across exchange rates.

Suggested Citation

  • Brennan, Michael J. & Xia, Yihong, 2004. "International Capital Markets and Foreign Exchange Risk," University of California at Los Angeles, Anderson Graduate School of Management qt53z0s29k, Anderson Graduate School of Management, UCLA.
    • Handle: RePEc:cdl:anderf:qt53z0s29k
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    Cited by:

    1. Antonio Diez De Los Rios, 2009. "Can Affine Term Structure Models Help Us Predict Exchange Rates?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 41(4), pages 755-766, June.
    2. Duarte, Margarida & Stockman, Alan C., 2005. "Rational speculation and exchange rates," Journal of Monetary Economics, Elsevier, vol. 52(1), pages 3-29, January.
    3. Brennan, Michael J, 2004. "How Did It Happen?," University of California at Los Angeles, Anderson Graduate School of Management qt1047x6kv, Anderson Graduate School of Management, UCLA.
    4. Georg Mosburger & Paul Schneider, 2005. "Modelling International Bond Markets with Affine Term Structure Models," Finance 0509003, University Library of Munich, Germany.

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