A bivariate model of exchange rates and interest rates : evidence of time-varying foreign exchange risk premia

Tay, Daniel (1998). A bivariate model of exchange rates and interest rates : evidence of time-varying foreign exchange risk premia Master's Thesis, School of Business, The University of Queensland.

       
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Author Tay, Daniel
Thesis Title A bivariate model of exchange rates and interest rates : evidence of time-varying foreign exchange risk premia
School, Centre or Institute School of Business
Institution The University of Queensland
Publication date 1998
Thesis type Master's Thesis
Supervisor Prof Stephen Gray
Total pages 124
Language eng
Subjects 14 Economics
Formatted abstract This thesis develops a bivariate empirical model of exchange rate changes and interest rate differentials between Germany and Japan vis-a-vis the United States. The distributions of both endogenous variables are conditioned on a latent jump variable where the probability of a jump varies over time as a function of financial and macroeconomic variables. The stochastic characteristics of exchange rate changes and interest rate differentials are modeled to behave differently in a "normal" regime and a ''jump'' regime.

Deviations from uncovered interest rate parity can be inferred from a regime where a large exchange rate jump is anticipated conditional on available information. Market participants price the anticipated jump risk and incorporate a sizeable foreign exchange risk premium on uncovered positions. The complete conditional distributions for exchange rate changes and interest rate differentials are specified allowing direct computation of the ''jump'' probability.

Evidence from this study suggests that currency risk premia are highly variable with sustained periods of high ''jump'' risk and periods where the likelihood of exchange rate jump is small. These Results imply that deviations from uncovered interest rate parity can be attributed, at least partially, to a time-varying foreign exchange risk premium.
Keyword Bivariate
Regime-Switching
Foreign Exchange Risk Premia
Uncovered Interest Rate Parity

 
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