35 Pages Posted: 4 Oct 2013
Date Written: November 2012
A basic tenet of lognormal asset pricing models is that a risky currency is associated with a low pricing kernel volatility. Empirical evidence implies that a risky currency is associated with a relatively high interest rate. Taken together, these two statements associate high-interest-rate currencies with low pricing kernel volatility. We document evidence suggesting that the opposite is true. We approximate the volatility of the pricing kernel with the volatility of the short-term interest rate. We find that, across currencies, relatively high interest rate volatility is associated with relatively high interest rates. This contradicts the prediction of lognormal models. One possible reason is that our approximation of the volatility of the pricing kernel is inadequate. We argue that this is unlikely, in particular for questions involving currencies. We conclude that lognormal models of the pricing kernel are inadequate for explaining currency risk.
Keywords: Asset Pricing, International Finance, Exchange Rate
Suggested Citation: Suggested Citation
Gavazzoni, Federico and Sambalaibat, Batchimeg and Telmer, Chris, Currency Risk and Pricing Kernel Volatility (November 2012). Available at SSRN: https://ssrn.com/abstract=2336034 or http://dx.doi.org/10.2139/ssrn.2336034
By Karen Lewis