International Stochastic Discount Factors and Covariance Risk

Posted: 23 Sep 2014 Last revised: 23 Nov 2020

See all articles by Nicole Branger

Nicole Branger

University of Muenster - Finance Center Muenster

Michael Herold

University of Bamberg

Matthias Muck

University of Bamberg

Date Written: November 2020

Abstract

We propose a Wishart Affine Stochastic Correlation (WASC) model for the joint dynamics of the SDF in an international economy. We derive exchange rate dynamics and a quasi-closed-form solution for currency option pricing. This solution includes Heston's stochastic volatility model as a special case. We benchmark our approach to a vector-based model inspired by Bakshi/Carr/Wu (2008, JFE). We estimate both models for the US, Europe, and Japan. Empirically, the WASC model is more robust with respect to the estimation period. In contrast to the benchmark model, estimated risk sharing indices seem to reflect the Euro crisis (2011/12) in the WASC model. Moreover, the explanatory power of filtered Sharpe ratios for stock market returns and volatilities is higher (both in- and out-of-sample).

Keywords: Stochastic discount factors, International model, Stochastic covariance, Stochastic risk premium, Wishart process, Currency options, Foreign exchange, Unscented Kalman filter

JEL Classification: G11, G13

Suggested Citation

Branger, Nicole and Herold, Michael and Muck, Matthias, International Stochastic Discount Factors and Covariance Risk (November 2020). Journal of Banking and Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=2499458 or http://dx.doi.org/10.2139/ssrn.2499458

Nicole Branger

University of Muenster - Finance Center Muenster ( email )

Universitatsstr. 14-16
Muenster, 48143
Germany
+49 251 83 29779 (Phone)
+49 251 83 22867 (Fax)

HOME PAGE: http://www.wiwi.uni-muenster.de/fcm/fcm/das-finance-center/details.php?weobjectID=162

Michael Herold (Contact Author)

University of Bamberg ( email )

Kaerntenstr. 7
Bamberg, 96052
Germany
+499518632093 (Phone)

Matthias Muck

University of Bamberg ( email )

Kärntenstr. 7
Bamberg, 96052
Germany
+49-(0)951-860-2091 (Phone)

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