SSE/EFI Working Paper Series in Economics and Finance
Annika Alexius and Peter Sellin
A Latent Factor Model of European Exchange Rate Risk Premia
Abstract: The floating of a number of European currencies in 1992-93
created a new body of data on risk premia on floating exchange rates. In
this paper, excess returns to investments in SEK, NOK, FIM, GBP, ITL and
EPT against the DEM are investigated. We model the risk premia as functions
of time varying second moments. First, univariate GARCH-M models are
estimated for each currency. It turns out that excess returns are
significantly higher in times of higher conditional variance for five of
the six currencies investigated. Then a latent factor GARCH model that
takes common effects in the different currency markets into account is
applied. We use a Kalman filter to identify the unobservable risk factors
and find evidence of risk premia in the sense that expected excess returns
are higher in times of high conditional volatility of the factors.
Expanding the model from one to two unobservable risk factors dies not
improve the fit significantly. While the average magnitude of the risk
premia is o.1-0.4 percentage points per year, they may reach 4-5 percentage
points in times of high risk.
Keywords: Exchange rate risk premia; latent factor models; (follow links to similar papers)
JEL-Codes: E43; F31; G12; (follow links to similar papers)
25 pages, January 1997
- This paper is forthcoming as:
Alexius, Annika and Peter Sellin, 'A Latent Factor Model of European Exchange Rate Risk Premia', International Journal of Finance and Economics.
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