Stochastic Risk Premiums, Stochastic Skewness in Currency Options, and Stochastic Discount Factors in International Economies

45 Pages Posted: 9 May 2005 Last revised: 13 Feb 2011

Peter Carr

New York University (NYU) - Courant Institute of Mathematical Sciences

Liuren Wu

City University of New York, CUNY Baruch College - Zicklin School of Business

Gurdip Bakshi

University of Maryland - Robert H. Smith School of Business

Date Written: December 20, 2006

Abstract

We develop models of stochastic discount factors in international economies that produce stochastic risk premiums and stochastic skewness in currency options. We estimate the models using time-series returns and option prices on three currency pairs that form a triangular relation. Estimation shows that the average risk premium in Japan is larger than that in the US or the UK, the global risk premium is more persistent and volatile than the country-specific risk premiums, and investors respond differently to different shocks. We also identify high-frequency jumps in each economy, but find that only downside jumps are priced. Finally, our analysis shows that the risk premiums are economically compatible with movements in stock and bond market fundamentals.

Keywords: Stochastic discount factors, international economy, stochastic risk premium

JEL Classification: G12, G13, F31, C52

Suggested Citation

Carr, Peter and Wu, Liuren and Bakshi, Gurdip, Stochastic Risk Premiums, Stochastic Skewness in Currency Options, and Stochastic Discount Factors in International Economies (December 20, 2006). Robert H. Smith School Research Paper No. RHS 06-154. Available at SSRN: https://ssrn.com/abstract=720501 or http://dx.doi.org/10.2139/ssrn.720501

Peter P. Carr

New York University (NYU) - Courant Institute of Mathematical Sciences ( email )

251 Mercer Street
New York, NY 10012
United States

Liuren Wu (Contact Author)

City University of New York, CUNY Baruch College - Zicklin School of Business ( email )

One Bernard Baruch Way
Box B10-225
New York, NY 10010
United States
646-312-3509 (Phone)
646-312-3451 (Fax)

HOME PAGE: http://faculty.baruch.cuny.edu/lwu/

Gurdip S. Bakshi

University of Maryland - Robert H. Smith School of Business ( email )

Department of Finance
College Park, MD 20742-1815
United States
301-405-2261 (Phone)
301-314-9157 (Fax)

HOME PAGE: http://scholar.rhsmith.umd.edu/gbakshi/Home?destination=Home

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