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
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: Suggested Citation