Abstract:
In this talk we show how to extend single-currency dynamic term structure models to a multi-currency setting. When the risk-neutral pricing measures, or risk premia, are denominated in two different currencies they must differ by the covariance of the exchange with the other factors in the model. As an illustrative example, we provide estimates for a Gaussian model of the term structure of swap rates and exchange rates in the G10 countries. There are 9 exchange rates and each yield curve is described by 2 or 3 factors, for a total of 37 factors in the model. The parameters that govern the covariances and risk-neutral drifts are relatively easy to estimate. However, it is much harder to reliably estimate the risk premia parameters that relate the risk-neutral and statistical measures. We examine the performance of models for 7 years out-of-sample and show that models with a small number of priced risk factors provide a good in-sample fit and the best out-of-sample results. This talk discusses joint work with Scott Joslin at MIT.