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A latent factor model of European exchange rate risk premia
Author(s) -
Alexius Annika,
Sellin Peter
Publication year - 1999
Publication title -
international journal of finance and economics
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.505
H-Index - 39
eISSN - 1099-1158
pISSN - 1076-9307
DOI - 10.1002/(sici)1099-1158(199907)4:3<217::aid-ijfe102>3.0.co;2-q
Subject(s) - economics , unobservable , econometrics , risk premium , interest rate parity , autoregressive conditional heteroskedasticity , foreign exchange risk , exchange rate , univariate , factor analysis , financial economics , currency , monetary economics , multivariate statistics , statistics , mathematics , volatility (finance)
The floating of a number of European currencies in 1992–1993 created a new body of data on foreign exchange risk premia, or deviations from uncovered interest rate parity (UIP). In this paper, excess returns to investments in SEK, NOK, FIM, GBP, ITL and ESP against the DEM are investigated. First, univariate GARCH‐M models are estimated for each currency and UIP is tested. UIP fares as badly on this data set as in most other studies. Then a latent factor GARCH model that takes common effects in the different currency markets into account is applied. The risk premia are modelled as functions of time varying factor variances. A Kalman filter is used to identify the unobservable risk factors. A one‐factor model that allows for idiosyncratic risk seem to fit the data quite well. However, the puzzling finding is made that the factor risk does not appear to be priced. Copyright © 1999 John Wiley & Sons, Ltd.