Currency Risk and Pricing Kernel Volatility

35 Pages Posted: 4 Oct 2013  

Federico Gavazzoni

INSEAD

Batchimeg Sambalaibat

Indiana University, Kelley School of Business

Chris Telmer

Carnegie Mellon University - David A. Tepper School of Business

Multiple version iconThere are 2 versions of this paper

Date Written: November 2012

Abstract

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

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

Federico Gavazzoni (Contact Author)

INSEAD ( email )

Boulevard de Constance
F-77305 Fontainebleau Cedex
France

HOME PAGE: http://federicogavazzoni.com

Batchimeg Sambalaibat

Indiana University, Kelley School of Business ( email )

1309 E 10th St
Bloomington, IN 47405
United States

HOME PAGE: http://https://sites.google.com/site/sambalaibat/

Christopher I. Telmer

Carnegie Mellon University - David A. Tepper School of Business ( email )

5000 Forbes Avenue
Pittsburgh, PA 15213-3890
United States
(412) 268-8838 (Phone)
(412) 268-6837 (Fax)

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