Common Factors and Local Factors: Implications for Term Structures and Exchange Rates

AbstractThis paper studies a multi-factor, two-country term structure and exchange rate model when a diversification effect for an international bond portfolio is expected. It shows that the diversification gain calls upon certain restrictions on the process of the stochastic discount factor in a factor-structured economy. Existence of local factors is shown to be a necessary condition for the gains from investing in foreign bonds. Further, the exchange rate risk premia are shown to be a function of the differentials of the risk premia of the factors in bond returns. Empirical results reveal the tendency for investors to respond sensitively to rare shocks, which is shown to be a potential solution to the forward premium puzzle.

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The Cross Section of Foreign Currency Risk Premia and Consumption Growth Risk: Comment

The American Economic Review ◽

10.1257/aer.101.7.3456 ◽

2011 ◽

Vol 101 (7) ◽

pp. 3456-3476 ◽

Cited By ~ 76

Author(s):

Craig Burnside

Keyword(s):

Foreign Currency ◽

Risk Premia ◽

Expected Returns ◽

Stochastic Discount Factor ◽

Forward Premium Puzzle ◽

Cross Sectional ◽

Consumption Growth ◽

Forward Premium ◽

The Cross ◽

Premium Puzzle

Lustig and Verdelhan (2007) argue that the excess returns to borrowing US dollars and lending in foreign currency “compensate US investors for taking on more US consumption growth risk,” yet the stochastic discount factor corresponding to their benchmark model is approximately uncorrelated with the returns they study. Hence, one cannot reject the null hypothesis that their model explains none of the cross sectional variation of the expected returns. Given this finding, and other evidence, I argue that the forward premium puzzle remains a puzzle. JEL: C58, E21, F31, G11, G12

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Does Macaulay Duration Provide The Most Cost-Effective Immunization Method – A Theoretical Approach

Foundations of Management ◽

10.1515/fman-2017-0008 ◽

2017 ◽

Vol 9 (1) ◽

pp. 99-110 ◽

Cited By ~ 2

Author(s):

Leszek Zaremba

Keyword(s):

Interest Rates ◽

Term Structure ◽

Theoretical Approach ◽

Empirical Studies ◽

Cost Effective ◽

Necessary Condition ◽

Future Time ◽

Bond Portfolio ◽

Sufficient And Necessary Condition ◽

Effective Immunization

Abstract In the following, we offer a theoretical approach that attempts to explain (Comments 1-3) why and when the Macaulay duration concept happens to be a good approximation of a bond’s price sensitivity. We are concerned with the basic immunization problem with a single liability to be discharged at a future time q. Our idea is to divide the class K of all shifts a(t) of a term structure of interest rates s(t) into many classes and then to find a sufficient and necessary condition a given bond portfolio, dependent on a class of shifts, must satisfy to secure immunization at time q against all shifts a(t) from that class. For this purpose, we introduce the notions of dedicated duration and dedicated convexity. For each class of shifts, we show how to choose from a bond market under consideration a portfolio with maximal dedicated convexity among all immunizing portfolios. We demonstrate that the portfolio yields the maximal unanticipated rate of return and appears to be uniquely determined as a barbell strategy (portfolio) built up with 2 zero-coupon bearing bonds with maximal and respective minimal dedicated durations. Finally, an open problem addressed to researchers performing empirical studies is formulated.

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New Evidence on the Forward Premium Puzzle

Journal of Financial and Quantitative Analysis ◽

10.1017/s0022109016000302 ◽

2016 ◽

Vol 51 (3) ◽

pp. 875-897 ◽

Cited By ~ 14

Author(s):

Jacob Boudoukh ◽

Matthew Richardson ◽

Robert F. Whitelaw

Keyword(s):

Exchange Rate ◽

Interest Rate ◽

Purchasing Power Parity ◽

Power Parity ◽

Forward Premium Anomaly ◽

Forward Premium ◽

Premium Puzzle ◽

The Interest Rate ◽

Exchange Rate Changes ◽

Interest Rate Differentials

AbstractThe forward premium anomaly (exchange rate changes are negatively related to interest rate differentials) is one of the most robust puzzles in financial economics. We recast the underlying parity relation in terms of lagged forward interest rate differentials, documenting a reversal of the anomalous sign on the coefficient in the traditional specification. We show that this novel evidence is consistent with recent empirical models of exchange rates that imply exchange rate changes depend on two key variables: the interest rate differential and the magnitude of the deviation of the current exchange rate from that implied by purchasing power parity.

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LEARNING, THE FORWARD PREMIUM PUZZLE, AND MARKET EFFICIENCY

Macroeconomic Dynamics ◽

10.1017/s1365100509080109 ◽

2009 ◽

Vol 13 (S1) ◽

pp. 31-57 ◽

Cited By ~ 6

Author(s):

Avik Chakraborty

Keyword(s):

Exchange Rate ◽

Least Squares ◽

Foreign Exchange Market ◽

Recursive Least Squares ◽

Generation Process ◽

Unknown Parameters ◽

Forward Premium Puzzle ◽

Forward Premium ◽

Premium Puzzle ◽

Parameter Values

The Forward Premium Puzzle is widely considered to indicate inefficiency in the foreign exchange market. This paper proposes a resolution of the puzzle using recursive least squares learning. Risk-neutral agents learn the unknown parameters, underlying the exchange rate generation process, using constant-gain recursive least squares. Simulations using plausible model parameter values replicate the anomaly along with other observed empirical features of the forward and spot exchange rate data. Estimates of parameter values from data support the model assumptions and justify the use of constant-gain learning. The conclusion is that the puzzle is not necessarily a reflection of inefficiency.

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The Term Structure of Currency Carry Trade Risk Premia

The American Economic Review ◽

10.1257/aer.20180098 ◽

2019 ◽

Vol 109 (12) ◽

pp. 4142-4177 ◽

Cited By ~ 10

Author(s):

Hanno Lustig ◽

Andreas Stathopoulos ◽

Adrien Verdelhan

Keyword(s):

Term Structure ◽

Developed Countries ◽

Risk Premia ◽

Investment Horizon ◽

Carry Trade ◽

No Arbitrage ◽

Bond Returns ◽

Foreign Bonds ◽

Term Premia

Fixing the investment horizon, the returns to currency carry trades decrease as the maturity of the foreign bonds increases. Across developed countries, the local currency term premia, which increase with the maturity of the bonds, offset the currency risk premia. Similarly, in the time-series, the predictability of foreign bond returns in dollars declines with the bonds’ maturities. Leading no-arbitrage models in international finance do not match the downward term structure of currency carry trade risk premia. We derive a simple preference-free condition that no-arbitrage models need to reproduce in the absence of carry trade risk premia on long-term bonds. (JEL E43, G12, G15)

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Cyclical and Persistent Carry Trade Returns and Forward Premia

Quarterly Journal of Finance ◽

10.1142/s2010139217500100 ◽

2017 ◽

Vol 07 (04) ◽

pp. 1750010 ◽

Cited By ~ 2

Author(s):

Haitham A. Al-Zoubi

Keyword(s):

Interest Rates ◽

Financial Economics ◽

Risk Premium ◽

Risk Premia ◽

Carry Trade ◽

Currency Risk ◽

Excess Returns ◽

Forward Premium ◽

Equilibrium Asset Pricing ◽

Premium Puzzle

We show that carry trade excess returns and forward premia of exchange rates possess persistent and clear business-cycle patterns. Our results contradict the peso model of hedged carry trade developed by [Burnside, C., M. Eichenbaum, I. Kleshchelski, and S. Rebelo, 2011, Do Peso Problems Explain the Returns to the Carry Trade?, Review of Financial Studies 24(3), 853–891.] and the overconfidence model of carry trade developed by [Burnside, C., B. Han, D. Hirshleifer, and T. Y. Wang, 2011, Investor Overconfidence and the Forward Premium Puzzle, Review of Economic Studies 78(2), 523–558.]. Our results support equilibrium asset pricing models and share the habit formation view of [Verdelhan, A., 2010, A Habit-Based Explanation of the Exchange Rate Risk Premium, Journal of Finance 65(1), 123–145.] that requires countercyclical risk premia. In bad times, when risk aversion is high and domestic interest rates are low, investors require positive currency excess returns. Consistent with [Lustig, H., N. Roussanov, and A. Verdelhan, 2014, Countercyclical Currency Risk Premia, Journal of Financial Economics 111(3), 527–553.] the cyclicality of excess returns is associated with the cyclicality of forward premia. We find that the persistence in forward premia and excess returns is related to their cyclicality. Our results are robust to the [Lustig, H., N. Roussanov, and A. Verdelhan, 2011, Common Risk Factors in Currency Market, Review of Financial Studies 24(11), 3731–3777; Lustig, H., N. Roussanov, and A. Verdelhan, 2014, Countercyclical Currency Risk Premia, Journal of Financial Economics 111(3), 527–553.] high-minus-low (HML) and “dollar carry trade” portfolios.

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