Pricing the Excess Volatility in Foreign Exchange Risk Premium and Forward Rate Bias. Issue 1 (2nd January 2022)

• Record Type: Journal Article
• Authors: Swan, Tina T.; Swan, Bruce Q.; Chen, Xinfu
• Is Part Of: Applied mathematical finance. Volume 29:Issue 1(2022)
• Page Start: 33
• Page End: 61
• Publication Date: 2022-01-02
• Subjects: Term structure -- risk premium -- forward bias -- affine model -- global factor -- gray rhino; Business mathematics -- Periodicals; 650.0151
• DOI: 10.1080/1350486X.2022.2108857
• Languages: English
• ISSNs: 1350-486X

Abstract

ABSTRACT: We present the pricing of the documented excess volatility of the foreign exchange risk premium, relative to the interest rate differential. By specifying a term structure of interest rate model, the physical probability measure along with the pricing kernels or discount factors are used to derive a system for the expected future spot rate and the forward rate. The theoretical loads are found by solving the Riccati ordinary differential equations, and dynamic factors are captured to set up the global factors for both currencies. It shows that we prove the interest-rate surfaces are almost identical to the empirical ones, and the theoretical interest rates are guaranteed to be positive.