International Stochastic Discount Factors and Covariance Risk

48 Pages Posted: 23 Sep 2014 Last revised: 3 May 2019

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: April 26, 2019

Abstract

This research studies different dimensions of heterogeneity between countries including heterogeneities in SDF dynamics, risk premium dynamics, and the relations between SDF and risk premium dynamics. We propose a Wishart Affine Stochastic Correlation (WASC) Model for SDF dynamics. This yields quasi-closed form solutions for currency options which include Heston's stochastic volatility model as a special case of our model. We estimate the model for the US, Europe, and Japan applying the unscented Kalman Filter. Empirical results suggest that Europe and Japan are more homogeneous with respect to the US than with respect to each other. Homogeneity between SDF is higher than homogeneity with respect to Sharpe ratios. Moreover, we observe occasional breakdowns in international risk sharing. As plausibility checks we relate estimated Sharpe ratios to economic fundamentals. We find significant relations, which are in line with economic intuition. The model also fits second exchange rate moments reasonably.

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 (April 26, 2019). 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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