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Affine Models of the Joint Dynamics of Exchange Rates and Interest Rates

Published online by Cambridge University Press:  13 August 2010

Bing Anderson ,
Peter J. Hammond  and
Cyrus A. Ramezani
Bing Anderson
Affiliation:
California Polytechnic State University, Orfalea College of Business, San Luis Obispo, CA 93407. bianders@calpoly.edu.
Peter J. Hammond
Affiliation:
University of Warwick, Department of Economics, Coventry, CV4 7AL, U.K. p.j.hammond@warwick.ac.uk.
Cyrus A. Ramezani
Affiliation:
California Polytechnic State University, Orfalea College of Business, San Luis Obispo, CA 93407. cramezan@calpoly.edu.
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Abstract

This paper extends the affine class of term structure models to describe the joint dynamics of exchange rates and interest rates. In particular, the issue of how to reconcile the low volatility of interest rates with the high volatility of exchange rates is addressed. The incomplete market approach of introducing exchange rate volatility that is orthogonal to both interest rates and the pricing kernels is shown to be infeasible in the affine setting. Models in which excess exchange rate volatility is orthogonal to interest rates but not orthogonal to the pricing kernels are proposed and validated via Kalman filter estimation of maximal 5-factor models for 6 country pairs.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 45 , Issue 5 , October 2010 , pp. 1341 - 1365
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2010

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