Stochastic Risk Premiums, Stochastic Skewness in Currency Options, and Stochastic Discount Factors in International Economies

Abstract

We develop models of stochastic discount factors in international economies that produce stochastic risk premiums and stochastic skewness in currency options. We estimate the models using time-series returns and option prices on three currency pairs that form a triangular relation. Estimation shows that the average risk premium in Japan is larger than that in the US or the UK, the global risk premium is more persistent and volatile than the country-specific risk premiums, and investors respond differently to different shocks. We also identify high-frequency jumps in each economy, but find that only downside jumps are priced. Finally, our analysis shows that the risk premiums are economically compatible with movements in stock and bond market fundamentals.

Keywords: Stochastic discount factors, international economy, stochastic risk premium

JEL Classification: G12, G13, F31, C52