Term Structure Models and the Risk Premium

Midwest Finance Association 2012 Annual Meetings Paper

Posted: 28 Sep 2011 Last revised: 25 Mar 2019

Date Written: January 25, 2015

Abstract

This paper utilizes the term structure model to study the forward premium. Throughout the theoretical development, the physical probability measure instead of the artificial risk-neutral measure, pricing kernels or discount factors, is used to derive a system of equations for the expected future spot rate and the forward rate. This allows us to model the behavior of the risk premium theoretically and empirically. We test the model using data on the Canadian-U.S. exchange rate. The dynamic factors are captured by Composite Principal Component Analysis (CPCA) which supplies a different way to set up the global factors for both currencies. The theoretical loads are found with the parameters chosen to match the ones from CPCA. It shows that interest-rate surfaces are presented almost identical to the empirical ones for both currencies, and the risk premium is examined at the same time within the term structures.

Keywords: Term Structure, Forward Premium, Exchange Rate, Affine Model, Global Factor

JEL Classification: E43; F31; G10; G12

Suggested Citation

Swan, Tina, Term Structure Models and the Risk Premium (January 25, 2015). Midwest Finance Association 2012 Annual Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1934594 or http://dx.doi.org/10.2139/ssrn.1934594

Tina Swan (Contact Author)

SUNY Buffalo State ( email )

1300 Elmwood Ave
Buffalo, NY 14222
United States

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