Professional Documents
Culture Documents
†
Serhiy Kozak
Abstract
This paper explores the relationship between bond and foreign exchange risk premia. I
extend the Cochrane and Piazzesi [2005] results across countries and for longer maturities. I
show that cross country bond risk premia are correlated and extract the global bond Cochrane-
Piazzesi factor (GCP). Excess returns on bonds of each country are modeled using two factors:
GCP and a country specic one. Excess foreign exchange returns are modeled using two factors
as well: the average interest rate dierential (home country specic factor, AD) and the global
carry trade factor. I further show that the global carry trade and GCP factors are related. AD
and GCP factors predict excess foreign exchange returns and their relative importance changes
with the currency risk (as measured by forward spread). Finally, I present a long-run risk model
that motivates the use of two factors in explaining foreign exchange excess returns.
∗
I thank John Cochrane, Eugene Fama, Lars Hansen, John Heaton and my classmates at Chicago Booth for
helpful comments and suggestions.
†
Booth School of Business and Department of Economics, University of Chicago. Email: kozak@chicagobooth.edu.
The latest version is available at http://home.uchicago.edu/skozak
1
1 Introduction
The paper explores the relationship between risk premia in bond and foreign exchange markets.
The two markets are closely linked: investing in foreign bonds often implies loading on currency
risk. Using available nancial instruments these two risks, however, can be decomposed into two
independent pieces: pure bond risk premium and pure foreign exchange risk premium. This decom-
position requires only that the currency forwards markets exist and are ecient. I show that excess
returns on foreign bonds in foreign currency are approximately equal to excess returns on foreign
While the decomposition allows us to study two markets separately, it is important to understand
how these two markets interact and whether they have common risk structure or can be hedged by
each other. This paper is the rst step towards understanding this question.
I rst start with extending Cochrane and Piazzesi [2005] results in the US by including forward
rates 6 through 10 in their regressions. The Cochrane-Piazzesi (CP) factor turns out to be very
robust and fully preserves the 1-5 forward rates structure while displaying an additional dip at a
loading on 8th year forward rate. Including 10 forwards raises an issue of overtting in a small
sample. I propose an empirical strategy to verify whether including additional lags in the regression
does indeed outperform original Cochrane and Piazzesi [2005] regression in short sample.
I then extend the analysis of bond markets to dierent countries. Cochrane and Piazzesi [2005]
showed that the single factor can predict bond excess return in the US at all maturities. This
factor is correlated with the US business cycle and hence is a good candidate for a risk premium
variable. Several papers (Kessler and Scherer [2009], Dahlquist and Hasseltoft [2010]) attempted
to extend the results of Cochrane and Piazzesi [2005] to other countries, but did not succeed. I
show that the problem lies in the data the papers use: they rely on yield curve datasets which are
smoothed across maturities. The Cochrane and Piazzesi [2005] regression estimates rely on multiple
dierencing of yields, and thus yield curve smoothing can destroy the very information being looked
for. The authors themselves use unsmoothed Fama and Bliss [1987] yields and hence preserve this
information. As a result, Cochrane and Piazzesi [2005] nd an attractive tent-shaped pattern of
loadings in their paper, while the other two papers mentioned lose this pattern altogether.
To deal with the data issues I propose using interest rate swaps dataset to estimate the CP
factor in other countries. The yields derived from interest rate swaps are not precisely zero-coupon
yields due to embedded default premium (through their dependence on the LIBOR rate). They turn
out, however, to produce better estimates of zero-coupon bond yields than the yields calculated by
Diebold and Li [2006], who employ the Fama and Bliss [1987] methodology to the actual bond
data. Interest rate swap rates are traded every day and thus do not have to be approximated by
other instruments with similar maturities. Moreover, the Fama and Bliss [1987] methodology has
diculties with the current crisis period which can be avoided by using swaps data.
By using interest rate swaps I nd similar tent-shaped factors in the UK, Germany, Japan and
Switzerland. The nding suggests that CP factor is also robust across countries. CP factors in
ve countries are correlated. Moreover, CP factors from foreign countries often help to predict
2
bond excess returns in the home country. I perform multiple tests to see how foreign risk premia
are related and aect each other. I also nd that a common component of all CP factors is an
important predictor of risk premia in each country and can hence serve as a global risk factor. The
central question is whether and how this risk is related to foreign exchange market risks.
I further investigate foreign exchange market predictability. To focus on the risk premia story
and minimize the noise in foreign exchange data, I work with forward-spot spread (or interest rate
dierential) sorted portfolios of currencies, similar to Lustig and Verdelhan [2007], Lustig et al.
[2010a].
Lustig et al. [2010a] nd that two factors explain the cross-section of foreign exchange returns.
Evidence on time-series predictability in foreign exchange market, however, are weak. Hansen and
Hodrick [1980], Fama [1984] were the rst to show that foreign exchange returns are predictable and
hence time-varying risk premia story is plausible. There are several potential sources of time-varying
risk premia in foreign exchange market. One is related to the Lustig et al. [2010a] level factor in
the cross-section the risk associated with the home country's currency movements. The other is
the global risk of dierential investment in one country vs. another (related to cross-section slope
factor) carry trade as a special case. This risk premium can also be time-varying. Lustig et al.
[2010a] showed that by sorting countries in portfolios and looking at the dierences in returns of one
portfolio vs. another, we are able to isolate common innovations to the stochastic discount factor
(SDF).
The choice of common and individual risk factors is consistent with the ndings in the literature.
Backus et al. [2001] nd that we need large common component with dierential loadings to explain
foreign exchange market anomalies. Brandt et al. [2006] document that large common component
is necessary to explain relatively low foreign exchange market volatility (relative to stock market).
This motivates the global risk factor in foreign exchange markets. Similarly, all exchange rates move
together when home country appreciates or depreciates. This home country currency movement
I therefore nd two factors to be important in explaining the time-series of foreign exchange
returns. The average interest rate dierential (AD) serves as a US-specic factor. It is signicant
for countries with low interest rates that face little risk of depreciation, but loses signicance in
countries with high interest rates. These countries, however, have signicant negative slopes on the
GCP factor, while the countries with low interest rates have insignicant slopes. In this story, the
carry trade strategy should be free of US-specic risk and load on global carry trade factor. I nd
that excess returns on carry trade load signicantly on the GCP factor which means that global
carry-trade and GCP factors are related. AD factor, however, has marginal predictive power on
carry trade excess returns as well, which suggests that GCP does not fully capture foreign exchange
global factor. AD has large global component and its ability to predict carry trade excess returns
The two factor approach allows us to link foreign exchange risk premium to that of bonds.
Indeed, bond risk premium can be modeled using two factors as well: a global Cochrane-Piazzesi
3
(GCP) factor and a country-specic CP factor. Bond market's GCP factor seems like a direct equiv-
alent of foreign exchange market's carry trade factor. Country-specic bond and foreign exchange
factors can be connected too. In terms of the risk premium macro story, we can expect global risk
factors be related to global business cycles while country-specic factors reect a country-specic
Finally, I present a long-run risk model that motivates the use of two factors in explaining
foreign exchange excess returns. The model features Epstein and Zin [1989] preferences together
with long-run predictable component in consumption as in Bansal and Yaron [2004]. Both the
consumption growth conditional variance and conditional variance of expected consumption growth
components are perfectly correlated across countries, while short-run news are i.i.d. The model
implies that the bond risk premia in each country is driven by conditional volatility of expected
consumption growth only. Therefore, if we believe that CP factor is a good proxy for expected
bond returns, we might use it to recover the conditional volatility. Expected currency excess returns
depend on both volatilities. It is further shown, that they can be recovered in a similar way using
US bonds excess returns on one- to ve-year maturities. This factor is a tent-shaped linear function
In this section I reproduce Cochrane and Piazzesi [2005] results at 5 year maturity and extend
them to maturities up to 10 years. I estimate CP factor in dierent datasets and conrm Cochrane
and Piazzesi [2009] claim that CP factor should be estimated using unsmoothed yields data.
I further estimate CP factors in four additional countries: UK, Japan, Germany and Switzerland.
The estimates suggest the same single factor structure with roughly the same shape in all countries.
To my knowledge this is a new result in the literature. Several papers, namely Dahlquist and
Hasseltoft [2010], Kessler and Scherer [2009], estimated CP factors in the same set of countries
but did not nd anything like the tent-shaped factor as in Cochrane and Piazzesi [2005]. These
seemingly contrary results are explained by the dierences in data used: both papers estimate the
CP factor out of smoothed zero-coupon yield curve datasets (either Datastream or Central Banks
of individual countries). In fact, using the same data as they do, I conrm that the estimates of
CP factor are nothing but noise huge negative and positive alternating loadings on forwards are
4
(n) (1)
brxnt+1 = brt+1 − yt
(n−1) (n) (1)
= pt+1 − pt − yt
2.1 US data
2.1.1 Cochrane and Piazzesi [2005] specication
Cochrane and Piazzesi [2005] nd a single factor to forecast bond risk premia. Their factor is a
(n) (2) (5) (n)
brxt+1 = bn γ0 + γ1 yt + γ2 ft + ... + γ5 ft + εt+1
They use a dataset constructed using Fama and Bliss [1987] methodology and available from
CRSP. I replicate their result using the same data in panel (A) of Figure 1. The sample is from
1965 till 2005. All loadings have the usual tent-shaped pattern. Simple factor structure looks like
a reasonable restriction and is further veried by the eigen-value decomposition of the covariance
matrix of expected returns. The rst principal component in such decomposition accounts for more
than 99% of the variance. The tted single factor constructed as in Cochrane and Piazzesi [2005]
Panel (B) plots the loadings of excess bond returns on ve forwards in the subsample of 1987-
2005. We see that the single factor tends to lose its shape as the size of the sample decreases. While
the general tent shape can still be observed, the factors load much more heavily on positive/negative
Panel (C) depicts the construction of CP factor using Gürkaynak et al. [2007] data. In con-
structing the yield curve, they follow the extension by Svensson [1994] of Nelson and Siegel [1987]
approach by assuming that the instantaneous forward curve can be parametrized by six parameters
n n n n n
ft (n, 0) = β0 + β1 exp − + β2 − exp − + β3 − exp −
τ1 τ1 τ1 τ2 τ2
Panel (C) shows that the factor loses its shape and predictive power altogether. Cochrane and
Piazzesi [2009] argue that this is due to data smoothing, which is insignicant for most of the
purposes, but aects the results when multiple dierencing of data is performed. In our case, excess
returns and forward rates are dierences of yields. Including multiple forward rates introduces even
I use three additional datasets to test robustness of the CP factor in alternative samples. The rst
one uses the yields on discount bonds inferred from interest rate swaps available from Datastream .
1
1
Interest rate swaps exchange a oating stream of payments for a xed one. Fixed interest is paid either annually
or semi-annually, depending on the country. All interest payments are discounted to period zero using a proper
5
Figure 1: US CP factor, dierent datasets and subsamples
2 4
2
0
0
−2 −2
1 2 3 4 5 1 2 3 4 5
−4 −5
1 2 3 4 5 1 2 3 4 5
2 1
0 0
−2 −1
−2
1 2 3 4 5 1 2 3 4 5
dierent maturity. Loadings increase linearly in maturity and thus the lowest variance line corresponds to maturity
of two years, while the highest to ten years. The dotted line with a triangular marker shows the extracted CP factor
loadings. Plot (A) replicates the results of Cochrane and Piazzesi [2005] by using Fama and Bliss [1987] dataset from
1965 to 2005. Plot (B) show results for the subsample of Fama and Bliss [1987] rates. Plot (C) uses Gürkaynak et al.
[2007] data (1965-2005). Plot (D) uses interest rate swaps data from Datastream (1987-2005). Plot (E) uses Diebold
and Li [2006] dataset. The last plot (F) shows the estimates for Diebold et al. [2007] dataset.
6
The resulting yields are not exactly the same as yields on zero-coupon bonds, since they also
include interest rate swap spreads (see Fehle [2003] or Due and Singleton [1997] for more technical
discussion). The main driver of the dierence is that interest rate swaps typically use LIBOR as a
oating reference rate, but LIBOR reects a default premium. The dierence between zero-coupon
and interest rate swap yields, however, is not very signicant empirically, and using swaps seems
like a reasonable approximation. One important benet of interest swap data is that it is much
cleaner interest rate swap rates are traded every day and thus do not have to be approximated
by other instruments with similar maturities. Panel (D) illustrates the CP factor extracted from
swaps. While the factor seems to lose a usual tent shape, it does look like a magnied version of
Another dataset is constructed by Diebold and Li [2006] and is available on Francis Diebold's
website. Diebold and Li [2006] use Fama-Bliss unsmoothed approach to estimate yields on zero-
coupon bonds. Unlike the Gürkaynak et al. [2007] procedure, forward curve is not approximated
by a Svensson [1994] functional form; instead, all the yields are extracted by back-substitution and
proper discounting. As a result, this delivers similar tent-shaped pattern as with original CRSP
seems to have problems with the fth coecient, but the rest are generally consistent with the
tent-shape pattern.
to data availability issue: Fama and Bliss [1987] yields on zero-coupon bonds are limited to only 5
years in maturity. Cochrane and Piazzesi [2009] add longer maturities by utilizing Gürkaynak et al.
[2007] dataset. They mention, however, that the yields are smoothed and therefore the information
in forward rates might be lost. Indeed, they nd that adding forward rates beyond 5 Fama and
Bliss [1987] rates introduces plenty of multicollinearity and has almost no improvement in terms of
R2 .
I use Diebold and Li [2006] dataset made available through Diebold's website. It contains
monthly yields from 1975 till 2000. Fama and Bliss [1987] algorithm is used to back out zero-
coupon bond yields. It is thus unsmoothed and, as I have shown before, the tent structure in rst
In Figure 2 I include 10 forward rates. Notably, tent shape is preserved in the rst 5 coecients.
Cochrane and Piazzesi [2005] showed that including 2-5 forwards traces the pattern of a tent shape.
Similarly, the specications of only 2 and up to 10 forwards were tested. The pattern of the
loadings traces that of Figure 2. Moreover, all loadings seem to maintain a single structure pattern.
discount factor. The discount factor is constructed using lower maturity swaps and linear interpolation for interim
payments.
2
I thank Francis Diebold and Canlin Li for providing the data.
7
Figure 2: US CP factor, maturities up to 10 years
(E) Diebold, 1970−2000
−2
−4
−6
1 2 3 4 5 6 7 8 9 10
dierent maturity. Loadings increase linearly in maturity and thus the lowest variance line corresponds to maturity
of two years, while the highest to ten years. The dotted line with a triangular marker shows the extracted factor
loadings.
Coecients on forwards with maturities above ve years are signicantly lower than those of a tent-
shape. 8-year forward rate seems to be important and is the only statistically signicant coecient.
This means that risk premium is high when long-horizon forward rate (8 years) is low. 6, 7, 9 & 10th
coecients are indistinguishable from zero. We may, however, still want to include some of those to
preserve the single factor structure in data. Figure 3 plots the estimates of CP factor together with
2 standard error bars. Standard errors are adjusted for time-series dependence using Hansen and
loadings again replicate the results in Cochrane and Piazzesi [2005] (see Figure 2, Panel C in their
paper). The pattern of loadings in this case warns us of potential multicollinearity problems that
is not signicantly dierent from zero. Further, forwards 6, 7 are insignicant from zero. I drop
the 7th one, but keep the 6th since it helps preserve single factor structure. Everything beyond 8th
3
For Hansen and Hodrick [1980] standard errors I use 252 lags for daily data at annual horizon. The number of
lags are scaled appropriately for wider horizons. For Newey and West [1987] standard errors (not reported) I used
1.5*252 lags for daily data to account for under-weighting of further lags in this estimation technique. For monthly
data and annual horizon 12 and 18 lags were used, correspondingly.
8
Figure 3: US CP factor, 10 forwards, 2 standard errors
−2
−4
1 2 3 4 5 6 7 8 9
The gure shows the loadings of average bond excess returns across maturities on ten forward rates and their standard
errors. These are the coecients γ in the regression brx(n) (2)
t+1 = γ0 + γ1 yt + γ2 ft
(10)
+ ... + γ10 ft + εt+1 . Error bars
depict two standard deviations intervals. Standard errors are Hansen and Hodrick [1980] with an appropriate number
of lags.
25
20
15
10
−5
−10
−15
−20
−25
1 2 3 4 5 6 7 8 9 10
Loadings increase linearly in maturity and thus the lowest variance line corresponds to maturity of two years, while
the highest to ten years. The dotted line with a triangular marker shows the extracted factor loadings.
9
Figure 5: US CP factor, selected forwards
−2
−4
1 2 3 4 5 6 7
dierent maturity. Loadings increase linearly in maturity and thus the lowest variance line corresponds to maturity
of two years, while the highest to ten years. The dotted line with a triangular marker shows the extracted factor
loadings.
The table reports R2 of bond excess returns regressions on the restricted linear combination of selected forward rates:
0
brxt+1 = γ f t + εt+1 . f t is constructed as the rst principal component of the covariance matrix of expected returns.
(n) (n)
Each column corresponds to an excess return of dierent maturity. Each row details which forwards are included in
forming the factor f t . First 4 rows correspond to the basic specication. The last 4 rows include 3 MA terms of f t
as in Cochrane and Piazzesi [2005].
10
Results with 1-5 forward rate are comparable to the ones reported by Cochrane and Piazzesi [2005].
Using information at the longer end (7-8 years) raises R2 even higher, all the way to 50-55% annually
(including 3 MA lags as in Cochrane and Piazzesi [2005]). Most of the marginal forecasting power
comes from the 8th forward rate which is signicantly negative. Indeed, χ2 test of coecients on
forward rates 6,7,9,10 being zero cannot be rejected, while including 8th forward rate in the test
results in a very strong rejection. In essence, this extension of Cochrane and Piazzesi [2005] factor
emphasizes the longer end of the forward curve and predicts higher risk premium at periods when
Discussion χ2 test strongly rejects the null that coecients 6-10 are jointly equal to zero (p-value
is above 0.999). The test is asymptotic, however, and may be misleading in a small sample, especially
with highly correlated regressors. On the one hand, Figure 4 is suggestive of multicollinearity. On
the other hand, the fact that the general shape is preserved when dropping explanatory variables
is comforting; however, small sample properties of such regressions still need to be explored.
One way to jointly test whether the 10-forwards specication is preferred to the usual Cochrane
and Piazzesi [2005] one in a small sample is to simulate the model that imposes an appropriate null.
Cochrane and Piazzesi [2009] may serve as such model. Their model ts the data well and hence
is relatively exible. It also imposes a strict structure that makes 5-forward CP factor the only
true variable governing the time-varying risk premium. Under this model, if taken as null, no other
forward rate should be able to help predict bond excess returns. It is therefore possible to simulate
the model, calculate forward rates form the underlying SDF and include them into bond excess
returns predictive regression. Under the null, forward rates beyond 5 year maturity are not relevant
for predicting expected returns and this fact allows us to construct condence bounds on R2 and
2
the distribution of χ statistics in a small sample that can be used to test our initial hypothesis.
Sections 6.1, 6.3 detail the model specication. Implementation of the test is an ongoing project.
countries. Four additional countries are analyzed: UK, Japan, Germany and Switzerland.
I rst start with the data available through the National Banks of these countries. This is exactly
what Dahlquist and Hasseltoft [2010] do. Each National Bank reports daily yields on zero-coupon
bonds. To estimate zero-coupon yields the Bank of England uses Svensson [1994] smoothing as
described in Anderson and Sleath [2001]. Swiss National Bank and Deutche Bundesbank follow a
similar approach as detailed in Bundesbank [1997]. Japanese Ministry of Finance uses piece-wise
Figure 6 shows the loadings on ve forwards for each country. The patterns have high positive
and negative zigzag loadings and suggest that the estimates are mostly driven by noise. Only
Japanese estimates seem to have a shape similar to that of the CP factor in Cochrane and Piazzesi
11
Figure 6: International CP factors, National Banks data
UK Japan
4
6 3
4 2
2 1
0 0
−2 −1
−4 −2
−3
1 2 3 4 5 1 2 3 4 5
Germany Switzerland
15
10
10
5 5
0
0
−5
−5 −10
1 2 3 4 5 1 2 3 4 5
The gure shows the loadings of bond excess returns at various maturities on ve forward rates in 4 coun-
tries.
Data from National Bankswebsites is used. These are the coecients γ in the regression brxt+1 =
(n)
12
[2005]. This is probably due to the fact that Japan uses piece-wise cubic spline approximation as
opposed to Nelson and Siegel [1987] or Svensson [1994] global approximation by a functional form.
Piece-wise approximation has much more degrees of freedom and should be better able to preserve
the information in yield dierences. Nonetheless, this simple exercise shows that the usual way of
estimating the yield curve implemented by most National Banks, while gives small errors for yields,
may be completely inadequate for the task (when multiple dierencing is needed). This is what has
In the next exercise I make use of the data generously supplied by Francis Diebold and Canlin Li.
Diebold et al. [2007] construct this dataset by implementing Fama and Bliss [1987] methodology.
As a result, unsmoothed zero-coupon bond yield at monthly horizon are produced. The sample
starts in September 1989 and ends in August 2005. I use this dataset to extract CP factors for
3 countries (UK, Japan and Germany). Results are reported in Figure 7. While the loadings are
very noisy, there is a major dierence between loadings for the UK and Germany in Diebold et al.
[2007] data and Central Banks' data in Figure 6: instead of going high and low in forward rates,
To deal with the data problems in Figure 7, I use interest swap rates to replicate the same
4
exercise . As it was mentioned above, while the interest rate swap data is not exactly zero-coupon
yields on riskless bonds, the quality of the data might be better due to the fact that swaps are
traded daily. With the daily swap data the stability of estimates increases greatly. The results of
this estimation are reported in Figure 8. Japanese and Switzerland's CP factors have clear tent
shape now. UK is still very noisy, but a similar pattern emerges. German's data have similar
pattern but not well estimated. There is a clear parallel between German's CP estimates and those
of the US in Panels (B) and (D) of Figure 1 they look almost identical, which suggests in favor of
The results are contrary to the ndings in Kessler and Scherer [2009]. The main dierence is
in using unsmoothed yields and longer sample. Kessler and Scherer [2009]'s sample includes only
10 years of data and the coecients and R2 of their regressions suggest vast overtting. Dahlquist
and Hasseltoft [2010] do not report the estimates of coecients, but my analysis of their data show
13
Figure 7: International CP factors, data from Diebold et al. [2007]
UK Japan
1.5 2
1
1
0.5
0 0
−0.5
−1
−1
−1.5 −2
1 2 3 4 5 1 2 3 4 5
Germany
1 1
0.5 0.5
0 0
−0.5 −0.5
−1 −1
1 2 3 4 5 0 0.5 1 1.5 2
The gure shows the loadings of bond excess returns at various maturities on ve forward rates in 4 coun-
tries.
Diebold et al. [2007] dataset is used. These are the coecients γ in the regression brx(n) t+1 =
14
Figure 8: International CP factors, interest rate swaps data
UK Japan
4
4
3
2
2
1
0 0
−1
−2 −2
−3
1 2 3 4 5 1 2 3 4 5
Germany Switzerland
15 4
3
10
2
5 1
0 0
−1
−5
−2
−10 −3
1 2 3 4 5 1 2 3 4 5
The gure shows the loadings of bond excess returns at various maturities on ve forward rates in 4
countries.
Interest rate swaps dataset
is used. These are the coecients γ in the regression brx(n)
t+1 =
15
Table 2: Fama and Bliss [1987] vs. Cochrane and Piazzesi [2005] performance
FB CP
β us uk jpn ger swz us uk jpn ger swz
2 0.40 0.20 1.19 0.10 0.38 0.56 0.31 0.45 0.41 0.41
(0.44) (0.27) (0.78) (0.54) (0.48) (0.16) (0.18) (0.04) (0.07) (0.13)
3 0.56 0.14 1.52 0.43 0.48 1.05 0.83 0.89 0.88 0.87
(0.55) (0.35) (0.82) (0.68) (0.53) (0.30) (0.32) (0.09) (0.13) (0.24)
4 0.62 0.16 1.60 0.45 0.49 1.44 1.24 1.23 1.23 1.22
(0.62) (0.44) (0.87) (0.70) (0.60) (0.41) (0.42) (0.13) (0.19) (0.31)
5 0.70 0.12 1.59 0.50 0.46 1.79 1.62 1.43 1.47 1.50
(0.67) (0.55) (0.99) (0.77) (0.71) (0.51) (0.49) (0.18) (0.23) (0.36)
R2
2 0.03 0.02 0.16 0.00 0.02 0.23 0.09 0.65 0.25 0.15
3 0.04 0.00 0.20 0.02 0.03 0.23 0.19 0.66 0.28 0.19
4 0.03 0.00 0.20 0.02 0.02 0.23 0.22 0.62 0.27 0.20
5 0.04 0.00 0.15 0.02 0.02 0.23 0.25 0.55 0.26 0.20
The estimates, standard errors and R2 of Fama and Bliss [1987] regression brx(n) (n)
t+1 = α + β ft
(1)
− yt + εt+1 are
(n)
reported in the left panel. Each row corresponds to a dierent maturity. The estimates, standard errors and R2 of
0
Cochrane and Piazzesi [2005] regression brxt+1
(n)
= γ f t + εt+1 are reported in the right panel. Standard errors are
(n)
the same level as for the US in Cochrane and Piazzesi [2005]. Japan is much more predictable,
but this is due to almost zero yields in the country in my sample. Cochrane and Piazzesi [2005]
regression R2 are signicantly higher than Fama and Bliss [1987] ones and the estimates of coecient
on explanatory variable are much more signicant than those in Fama and Bliss [1987] regression.
4
Time series span the period from 1987 till 2010. I exclude the last year and the rst 1-2 years of some series to
match them in size. Further, one year swap rates start only in 1994. To extend the sample I substitute one year
LIBOR rates in place of missing observations for one year interest rate swaps. LIBOR rates have higher spread so
this substitution is not entirely warranted, but the missing sample is only about 5 years and single maturity, so the
benet of substituting non-perfect data outweighs the downside of losing 5 years of all yields. It is worth mentioning
that standard errors on all estimates are high and the estimates are not particularly robust to including/excluding
data. This is due to a very short sample used. The problem is present also in US Fama and Bliss [1987] dataset when
limiting attention to the sample of the same size.
5
Here and henceforth I do not account for the parameter uncertainty when performing the second stage of Cochrane
and Piazzesi [2005] estimation (regressing excess returns on a single factor that had been estimated in the rst stage).
In principle, standard errors should be adjusted appropriately to account for this fact. To facilitate comparison with
Cochrane and Piazzesi [2005] and for simplicity reasons, however, I omit this adjustment.
16
2.3 Links between CP factors across countries
2.3.1 Excess returns equivalence
Excess return on foreign investment in bonds is approximately equal to the excess return that US
investor can achieve by participating in foreign bond market and converting proceeds using forwards
U K,$ U K,¿
brt+1 ≈ brt+1 − (ft − st )
U K,¿
= brt+1 − iU
t
K
− iU
t
S
This strategy involves buying British pounds today for st , buying a forward contract on tomor-
row's proceeds at ft and gaining UK bond excess returns in pounds in between. Note that the
identity is approximate since the return at t+1 is uncertain as of time t. Bonds returns, however,
are not very volatile and the uncertainty in interest is negligible compared to the principal plus
expected interest. It is therefore a reasonably good approximation to consider. The second line in
brxU K,$
t+1
U K,$
= brt+1 − iU
t
S
U K,¿
≈ brt+1 − iU
t
K
− iU
t
S
− iU
t
S
U K,¿
= brt+1 − iU
t
K
K,¿
= brxU
t+1
It immediately follows that we can simply look at bond excess returns in dierent markets
Figure 9 shows the cross-correlations of foreign CP factors with the US CP factor (including
autocorrelation). Correlation is the highest at the same period and is decaying going forward or
backwards. Therefore it does not seem that either of foreign CP factors is lagging behind the US
CP factor. It also shows that CP factor is quite persistent and high US CP factor today means
17
Table 3: Correlations between CP factors
us
0.9 uk
jpn
0.8 ger
swz
0.7
0.6
0.5
0.4
0.3
0.2
0.1
−0.1
−1 −0.5 0 0.5 1
Cross-correlations between US and CP factors of other countries are plotted. The top line shows the US autocorrela-
tion function. Other lines show how lead/lags of various countries CP factors are correlated with the contemporaneous
US CP factor,corr(CP U S , CPtf oreign ).
18
Table 4: R2 of excess returns on GCP factor
Motivation Suppose bond excess returns are driven by two factors: global and country-
specic. This is quite general, since multiple factors can be combined into one by forming a linear
combination. Then excess return has the following form: rxit+1 = αi + β i GFt + γ i Fti + εit+1 . We
i
want to form a linear combination of rxt+1 across i i
so that idiosyncratic factors Ft average out as
Optimal weighting should put maximal weight on the countries with the lowest variance of
idiosyncratic factors, since those provide the strongest signal. However, since countries have dierent
loadings on the global factor, there is no way to estimate the variance of idiosyncratic components;
therefore, weighting is arbitrary. The easiest way would be to form a simple average. Alternatively,
Dahlquist and Hasseltoft [2010] propose to use a GDP-weighted linear combination of individual
countries' CP factors. While there is no particular reason to choose GDP-weighting per se, it may
reect our desire to put more emphasis on bigger countries assuming that they have higher loadings
on the global factor and relatively lower on idiosyncratic. Proceeding in this way I estimate GDP
weights to be: 0.5461, 0.1033, 0.1902, 0.1414, 0.01905 for the US, UK, Japan, Germany, Switzerland,
correspondingly.
Figure 10 shows CP factors in dierent countries and the global GDP-weighted CP factor. Blue
line shows CP factors of each country in this country's own currency. Red line is the average of
Further, I regress bond excess returns on the newly constructed global CP factor (GCP). The
R-squares are reported in the Table 4. The estimates suggest that there might be a common risk
factor that explains bond excess returns of each country. It is, however, still plausible that the factor
constructed above helps us forecast bond excess return in each country only because it embeds a
In the next section I include all ve CP factors on the RHS of regressions for each individual
Multiple CPs Each country's excess return is regressed on 5 international CP factors. Table
5 shows the estimates. Coecient estimates and standard errors are from regressions of average
19
Figure 10: CP factors across countries
0.06
US CP
0.04
GCP
0.02
0
89 90 91 92 93 94 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
0.06
UK CP
0.04
GCP
0.02
0
89 90 91 92 93 94 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
0.06 JPN CP
0.04
GCP
0.02
0
89 90 91 92 93 94 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
20
0.06 GER CP
0.04
GCP
0.02
0
89 90 91 92 93 94 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
0.06
SWZ CP
0.04
GCP
0.02
0
89 90 91 92 93 94 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
CP factors of ve countries and GCP factor are plotted. Blue line shows the country-specic CP factor. Red line is the same on all graphs and depicts GCP
factor (GDP-weighted linear combination of all CP factors).
Table 5: Excess returns on 5 CP factors
Estimates and t-statistics of the regression of average excess returns on 5 CP factors are shown in the top section of
the table. Each column corresponds to a dierent regression. The bottom section reports R2 of excess returns across
maturities on 5 CP factors. Each row corresponds to a dierent maturity. Standard errors are Hansen and Hodrick
[1980] with an appropriate number of lags.
across maturity excess returns on 5 CP factors. R2 are given separately for each maturity. R2 are
high, t-stats show that individual CPs are important for each country except UK. Further, the US
CP factor seem to be important for all countries, while it is the only one signicant in US excess
returns regression. UK is fully explained by the US and German CPs. The German CP factor
Surprisingly, UK loadings are negative. It's hard to tell whether it is a problem with UK
estimates which were the least precise or an actual pattern in data. Multiple tests of excluding
some countries showed that the dierence between US and UK CP factors is an empirically relevant
variable. It might be that the dierence in US and UK risk premia reveals some information about
Although the regression restricts the inuence of other countries on home country's expected
return to individual CP factors, it is quite exible in the sense that it allows dierential impact of
one country onto another. This exibility, however, complicates the risk premia story. Ultimately
we would like to move towards using some global factors (with dierential loadings across countries)
and home-specic, rather than a separate one for each foreign country.
Restricting the shape of CP factor Fama-Bliss dataset is much longer than interest rate swaps
dataset and thus CP factor loadings can be estimated much more precisely in the US. Given obvious
similarities in shapes of CP factor across countries and poor estimates there, it then makes sense to
21
Table 6: R2 of excess returns on 5 forwards principal components
The table shows the R2 of excess returns on 5 principal components of all international forward rates (up to 5 years
maturity, 25 in total).
restrict the shape of the CP factor in every country to that of the US, but estimate the factor itself
I performed this as a robustness exercise. Both bond and foreign exchange (to be discussed
later) results turn out to be robust to this modication. While some R2 estimates change a little,
the general pattern of two factor structure in bond markets and correlations between bond and
Estimating global factor using all forward rates The analysis above imposes the restriction
that expected excess bond returns in each country are governed by CP factors only, i.e. it imposes
that there is no marginal information in other countries' yield curves beyond that in their individual
CP factors.
Another way is to use all the information in forwards of each country. One way would be to
regress excess return of each country on all forwards (5 per 5 countries). They are, however, subject
to multicollinearity and overtting issues. Another approach is to rst extract common factors out of
all 25 forwards and use only those to predict excess returns of each country. This is similar to using
5 CP factors in the section above, but does not impose that CP is the only source of information;
rather, it uses ve orthogonal components that maximize the variance in forward curves.
It might be important to use forwards, rather than yields as emphasized by Cochrane and
Piazzesi [2005]: CP factor in yields is not well captured by 3-4 rst principal components. I
estimated this exercise both for forwards and yields. Five principal components of forward rates
Using from 5 to 10 principal components of all 25 forward rates produces very high R2 (40-70%).
The loadings, however, are hardly interpretable and are prone to reect simple overtting in a short
sample. It is hard to say how robust the results are and how well they perform out of sample. R2
are shown in Table 6. R2 are higher than when using 5 CP factors, but the estimates are dicult
to interpret. They should not, however, be suering from overtting much more than ordinary
Cochrane and Piazzesi [2005], since principal components simply maximize the variance in forwards
regardless of its predictive power on excess returns and the number of regressors stays the same.
This strategy is similar to Driessen et al. [2003] who nd that rst ve principal components
explain about 96.5% of the variation in international bond returns in US, Germany and Japan.
22
Either way, information in the yield curve of other countries often helps us to predict excess
returns in home country. This eect is quite dierentiated across countries, but there does seem
to be some convergence. The US CP factor, for example, seems to be important for most of the
countries excess returns. It is then plausible to assume that part of the risk in each country is
common. This risk may reect the overall business cycle risk of the world (see, for example, Kose
et al. [2003]).
Since global risk premium factor loads heavily on the US CP factor and the US CP factor has
been shown to be correlated with US business cycles (see Cochrane and Piazzesi [2005]), it is natural
that global bond risk premium is correlated with US business cycles variables.
One global, one local factor While the exibility of including multiple CPs into one regression
seems more general, if we are looking for a common risk premia as a compensation for some sort of
macroeconomic risk, we should limit our attention to few common factors that explain the cross-
section within and across countries and time-series of international bond markets.
CP factor is a successful predictor of bond excess returns of a country ignoring all other countries.
This factor succinctly summarizes the predictive information in the cross-section of all bonds within
a country. When we consider the world of multiple countries, however, CP factors should be linked
together. If marginal utility today is high in the US and hence risk premium is high in the country,
it should be raising in other countries too, given that the markets are complete and investors are
free to participate in international markets. If this was not the case and expected excess returns
were low, say in the UK, and hence their marginal utility was relatively low too, UK investors would
nd the US bond market particularly protable and would arbitrage away any dierences in pricing
I therefore model bond the risk premium of each country using two factors as in Dahlquist
and Hasseltoft [2010]. The GCP factor is a global factor that moves risk premia of all countries
together. Every country has its own loading on this factor. In addition, each country loads on its
country-specic CP factor which I dene as a residual of regressing its actual CP factor as dened
in Cochrane and Piazzesi [2005] on the GCP factor constructed above. Such a construction has a
very natural risk premia avor and furthermore will be easily linked to foreign exchange risk premia
Estimates of excess return regressions (average over horizons) on GCP are shown in Table 7.
I decompose it into the global CP and a country-specic CP. See section 6.4.1. This allows us to
study the global CP as a compensation for global risk. Having a common factor in SDFs of dierent
countries is important to understand foreign exchange market phenomena (see, for example, Brandt
et al. [2006]).
23
Table 7: Excess returns on GCP and country-specic CP
Estimates, t-statistics and R2 of average excess returns on GCP and country-specic CP residuals are reported. The
latter are formed by regressing country-specic CP on GCP and taking out the residuals. Standard errors are Hansen
and Hodrick [1980] with an appropriate number of lags.
of excess returns in this market and that bond and foreign exchange markets are linked. Similarly
to bonds, two factors will be identied: a country-specic one and the global factor. I will show
that the GCP bond factor and the global foreign exchange factor are related and that GCP factor
says:
ft − st = i∗t − it
I dene excess foreign exchange return f rxt+1 as a dierence in forward rate today and spot
rate tomorrow:
f rxt+1 = ft − st+1
= i∗t − it − ∆st+1
which is equivalent to a strategy of investing in one year foreign bond for one year (with prede-
this result. I extend their results to longer sample (they used 1980-2000) and include interim
24
Table 8: Long-run regressions
The table presents the estimates and standard errors of UIP regressions ∆st+1 = α + β (i∗t − it ) + εt+1 at horizons
from 1 to 7 years. Interest rates correspond to the period length, e.g. in 7 year regression, 7-year interest rates are
taken. Standard errors are Hansen and Hodrick [1980] with an appropriate number of lags. The sample starts in
1970 for UK, 1973 for Japan, 1974 for Germany and 1983 for Switzerland. All samples end in 2010.
maturities.
Table 8 shows the estimate of ∆st+1 = α + β (ft − st ) + εt+1 regression. It reconrms the puzzle
at annual horizon: UIP predicts slope estimate to be equal to 1, while the estimate I get is below
zero. This suggests that the currency of high interest country appreciates on average instead of
depreciating. I extend the regressions up to 7 year horizon and report the results in the table. We
can see that the slope estimate consistently increases with horizon and approaches 1 at longer end.
Regressions at the 7-year horizon with less than 40 years of data raise some statistical issues. In
essence, we have only 5-6 independent datapoints and the results might well be sample-specic. Still,
the coecient seem to be moving in the right direction and the results are somewhat comforting.
Moreover, this is indeed a pattern that we observe by looking at foreign exchange and interest rate
The evidence suggests in favor of the risk premium story. Foreign exchange markets seem to
be priced according to UIP at longer horizon and hence we do not observe pervasive mispricing.
Instead, it might be that at the shorter end the violation of UIP reects some risk premia that
is present at annual frequency but vanishes at lower frequencies. This risk premium seems to be
25
3.3 Data
Exchange rates are very noisy. Diversiable country-specic risk should not be priced. Therefore,
using individual countries' exchange rates contributes little to the risk premia story. Once we
decide to focus on the risk premia, it is much more sensible to use Fama-French portfolio approach
as implemented in Fama and French [1992] for stock markets and in Lustig et al. [2010a] for foreign
exchange. Moreover, Lustig et al. [2010a] argues that by sorting countries into portfolios, we can
I use daily spot and forwards rates provided by Datastream. I also take Eurocurrency Financial
Times interest rates and substitute them in place of forward rates according to the covered interest
rate parity (when the longer data series are available). Spots, forwards and interest rates come from
various datasets:
I then combine those series country by country in order to get the longest time series. Each country
is added to the sample as its data become available. Euro area countries are removed at the dates
Portfolios Portfolios are rebalanced every day basing on the average of forward spread in the
recent month (22 days before the current date). I add and drop countries to portfolios as the data
becomes available. In 1975 data only 5 countries are available; another 12 countries are added before
1984 and the rest are included as the data appears. Euro area countries are listed up until 1998
Using available data, I form 8 portfolios at each date. The number is chosen to be the same as
in Lustig and Verdelhan [2007] who nd that this number is optimal in separating highest interest
closely mirrors Table 1 in Lustig et al. [2010a]. I also added standard errors of the estimated sample
moments which are corrected for serial correlation using the Hansen and Hodrick [1980] approach.
For each portfolio numbered 1-8 I report ft − st dierential, change in spot rates ∆st+1 and risk
premium ft − st+1 . All variables are annualized and shown in percentage terms.
26
Table 9: All countries, forward-spot spread sorted portfolios
1 2 3 4 5 6 7 8
ft − st -3.35 -1.76 -0.93 0.23 1.13 1.97 3.86 6.88
(0.16) (0.14) (0.14) (0.12) (0.11) (0.13) (0.16) (0.23)
∆st+1 -1.33 -0.15 0.14 -0.41 0.39 -0.25 0.47 4.20
(0.85) (0.76) (0.67) (0.80) (0.70) (0.78) (0.83) (0.88)
ft − st+1 -2.01 -1.62 -1.07 0.64 0.75 2.22 3.40 2.68
(0.92) (0.80) (0.70) (0.84) (0.73) (0.82) (0.83) (0.89)
For each portfolio numbered 1-8 the table reports ft − st dierential, change in spot rates ∆st+1 and risk premium
ft − st+1 . All variables are annualized and shown in percentage terms. Standard errors are Hansen and Hodrick
[1980] with an appropriate number of lags.
The rst row of the Table 9 simply mirrors the sorting criteria: forward spread increases for
every subsequent portfolio. The third row shows a spot change for every portfolio. UIP predicts
that the entire magnitude of ft − st comes from a change in spot rates. Hence ∆st+1 of a portfolio
should be equal to the ft − st as well, if UIP were to hold. This is equivalent to saying that ft − st+1
is equal to zero for each portfolio. We see, however, that the estimates of ∆st+1 for all portfolios are
consistently less than corresponding ft − st (or ft − st+1 are not zero) the point made by Lustig
et al. [2010a]. Lustig et al. [2010a], however, do not report standard errors of the estimates and we
While the standard errors of the estimates are large, some patterns become quite obvious.
Forward-spot dierential contains the information about both future spot change and risk premium
(the sum of rows 3 and 5 is the same as row 1 by construction). As we move from portfolios with
low forward-spot dierential (portfolio 1) to those with high (portfolio 8), spot change ∆st+1 and
risk premium ft − st+1 are moving in the same direction. Further, for high interest portfolios except
the last one (the most risky countries) the spread in risk premium between this high portfolio and
portfolio 1 is larger than the dierence in ∆st+1 between those portfolios. This is consistent with
the Fama [1984] nding that most of the variation in the forward rates is variation in premiums.
umented by Hansen and Hodrick [1980], Fama [1984], Lustig et al. [2010a]. Moreover, empirical
evidence suggests that the information in forward rates potentially contains both the risk premium
and the expected change components. This is consistent with Fama [1984] who nds that both parts
of forward rates vary through time. Most of the variation comes from the premium. It is therefore
interesting to analyze the risk premium and expected spot change components in more detail.
27
ft = Et (st+1 ) + pt
ft − st = (Et st+1 − st ) + (ft − Et st+1 ) (1)
= qt + pt
where qt denotes expected spot change, Et st+1 −st , while pt denotes the risk premium, ft −Et st+1 .
Further, following Fama [1984], Backus et al. [2001], coecient β∆s can be calculated as:
If risk premium is constant, we get β∆s = 1 UIP hypothesis. In order to have negative β∆s ,
we need cov (q, p) + var (q) < 0. Fama [1984] argues that this requires negative covariance between
and perform the exercise at dierent horizons. I also work with 8 portfolios, similar to Lustig and
Verdelhan [2007]. I rst start with the eigenvalue decomposition of excess returns and extracting
three principal components of this decomposition. The loadings of each factor on 8 portfolios are
As in Lustig et al. [2010a] I nd two-three factors to be important. The rst two level and slope
have distinctive shapes and a very intuitive interpretation. Lustig et al. [2010a] calls the level factor
a dollar factor. The factor moves all currencies together and eectively mirrors the movements
of the home currency. Slope factor corresponds to a carry trade risk premium in the cross-section.
Lustig et al. [2010a] provides a detailed analysis of this factor and shows that covariances line up
nicely with the expected returns and thus the factor can indeed be interpreted as a risk factor.
The loadings of each portfolio and percentages of variance explained by each factor are shown
in Table 10. First two factors explain about 81% of the variation in currency expected returns and
hence can be useful as a way of summarizing the cross-sectional information of foreign exchange
returns.
related to the Lustig et al. [2010a] level factor in the cross-section the risk associated with the
home country's currency movements. The other is the global risk of dierential investment in one
country vs. another (related to cross-section slope factor) carry trade as a special case. This
risk premium can also be time-varying. Lustig et al. [2010a] showed that by sorting countries in
portfolios and looking at the dierences in returns of one portfolio vs. another, we are able to isolate
28
Figure 11: Cross-sectional factors at dierent horizons. To extract factors, I perform eigen-value
decomposition of portfolio covariance matrix.
1 months 3 months
0.6
0.4 0.4
0.2 0.2
0 0
6 months 12 months
0.6
0.4
0.4
0.2
0.2
0
0
−0.2
−0.2
−0.4
−0.4
−0.6
2 4 6 8 2 4 6 8
The gure shows the loadings of each factor on 8 portfolios. Each plot corresponds to a dierent horizon. Three
factors are depicted: level, slope and curvature.
1 2 3 4 5 6 7 8
p1 0.39 0.57 0.03 0.51 0.08 0.02 0.50 0.10
p2 0.33 0.37 -0.70 -0.19 -0.25 -0.05 -0.35 -0.21
p3 0.30 0.07 0.11 -0.10 0.87 0.04 -0.34 -0.14
p4 0.39 0.05 0.26 -0.20 -0.22 0.46 -0.28 0.63
p5 0.33 -0.07 0.08 -0.41 0.00 -0.76 0.21 0.29
p6 0.36 -0.02 0.56 0.15 -0.37 -0.15 -0.28 -0.54
p7 0.36 -0.32 -0.09 -0.40 0.00 0.42 0.55 -0.35
p8 0.36 -0.66 -0.32 0.54 0.02 -0.09 -0.10 0.16
% var 72.75 8.00 4.59 3.81 3.29 2.73 2.53 2.31
Each row corresponds to one portfolio; each column corresponds to a factor. The last row shows the fraction of
variance explained by each factor (in percent).
29
common innovations to the stochastic discount factor (SDF). See section 6.5 for more details on
their specication.
The choice of common and individual risk factors is consistent with the ndings in the literature.
Brandt et al. [2006] point out that we need a large common component in SDFs to reconcile high
volatility of SDF (that prices stock market) versus relatively low volatility of exchange rates. Backus
et al. [2001] showed that countries should have dierential loadings on the common component of
an SDF. This motivates the global risk factor in foreign exchange markets. Similarly, all exchange
rates move together when home country appreciates or depreciates this home country currency
Portfolio-specic factor If UIP were to hold, we would observe spot rates moving one to one
with interest rates. This is not what we observe in data at annual frequency. Alternatively, if ∆s
were a random walk, the interest rate dierential would be the only predictor of foreign exchange
risk premium. This motivates using the interest rate dierential in foreign exchange risk premia
forecasting regressions. However, we know that changes in spot rates are somewhat predictable,
both by macro variables and yield curve variables (see Ang and Chen [2010], for example). It is
In particular, in terms of the risk premium explanation, we are interested in nding a factor that
is independent of each particular portfolio, but may include a summary statistics of all currency
PN
portfolios. One such statistic may be an average of interest rate dierentials
1
N k=1 i∗k
t − it .
Alternatively we may form an optimal linear combination similar to what Cochrane and Piazzesi
[2005] do for bonds across maturities. The idea behind each of this predictor is that it is not an
interest rate dierential between two countries that matter, but rather the level of home interest
rates relative to the average interest rate in the basket of all countries. This variable is intended
to proxy for marginal utility of home investors and hence can potentially be helpful in explaining
spreads of 8 portfolios. If there was a single factor like the one found in Cochrane and Piazzesi
N
rxjt+1 = αrx (ftp − spt ) + εrx,t+1
X
j j,p
+ βrx
p=1
N
j,p ∗p
X
j
= αrx + βrx it − it + εrx,t+1
p=1
we should be able to nd a common pattern in portfolio loadings across portfolios. Table 11 reports
the coecients and standard errors of these loadings. Figure 12 shows the same loadings graphically.
The loadings as seen in Figure 12 have quite dierent patterns and do not seem to be governed
by a single factor as the CP factor in Cochrane and Piazzesi [2005]. More importantly, loadings
30
Table 11: Portfolio Loadings
1 2 3 4 5 6 7 8
α 0.02 0.04 0.04 0.08 0.06 0.08 0.11 0.04
[0.49] [0.84] [0.80] [1.54] [1.72] [1.79] [2.10] [0.73]
β1 2.39 1.24 2.47 2.97 2.93 1.89 2.77 2.59
[1.86] [0.78] [2.58] [2.10] [2.04] [1.25] [1.44] [1.21]
β2 -1.00 0.27 -1.96 -2.23 -1.49 -0.62 -1.58 -1.28
[-0.43] [0.13] [-1.44] [-1.17] [-0.96] [-0.37] [-0.82] [-0.57]
β3 -0.07 -0.30 0.93 0.67 0.36 0.32 0.25 0.62
[0.12] [-0.66] [1.71] [0.71] [0.56] [0.61] [0.35] [0.92]
β4 1.03 0.52 -0.81 0.84 -1.26 -0.92 -1.23 -1.59
[0.56] [0.34] [-0.88] [0.58] [-1.27] [-0.44] [-0.71] [-0.74]
β5 0.37 0.06 0.13 -2.20 -0.58 -0.82 -2.41 -1.70
[0.27] [0.07] [0.13] [-1.76] [-0.71] [-0.64] [-1.84] [-1.09]
β6 1.99 2.12 1.35 3.10 2.48 2.93 3.22 1.84
[2.35] [2.44] [1.72] [2.95] [2.35] [2.84] [3.38] [2.23]
β7 -0.94 -1.67 -0.24 -0.69 -0.22 0.08 0.12 -0.05
[-0.67] [-1.66] [-0.24] [-0.62] [-0.20] [0.05] [0.08] [-0.04]
β8 0.13 0.12 -0.13 -0.20 -0.18 -0.75 -0.63 0.64
[0.18] [0.18] [-0.23] [-0.36] [-0.40] [-1.16] [-0.82] [0.98]
R2 0.30 0.19 0.16 0.24 0.22 0.19 0.13 0.11
Each column corresponds to one portfolio and gives the estimates of coecients in the regression rxjt+1 = αrx j
+
PN
β
p=1 rx
j,p
(f p
t − sp
t ) + ε rx,t+1 . The left panel reports the coecients, while the right one reports standard errors. The
last row reports R2 of 8 regressions. Standard errors are Hansen and Hodrick [1980] with an appropriate number of
lags.
31
Figure 12: Loadings on all forward-spot spreads and an extracted single factor
2 2 2
Loadings
Loadings
Loadings
0 0 0
−2 −2 −2
2 4 6 8 2 4 6 8 2 4 6 8
Portfolio 4 Portfolio 5 Portfolio 6
2 2 2
Loadings
Loadings
Loadings
0 0 0
−2 −2 −2
2 4 6 8 2 4 6 8 2 4 6 8
Portfolio 7 Portfolio 8 All loadings
2 2 2
Loadings
Loadings
Loadings
0 0 0
−2 −2 −2
2 4 6 8 2 4 6 8 2 4 6 8
Blue solid line in each graph shows the loadings of each portfolio on 8 forward-spot spreads. Red dotted line shows
an extracted single factor as the rst principal component of all 8 loadings. The last gure plots all loadings in a
single graph to assess single factor structure.
32
Table 12: Return predictability with AD factor
1 2 3 4 5 6 7 8
FB
βrx 2.96 2.07 1.53 2.80 2.20 2.18 0.36 0.76
(0.41) (0.45) (0.46) (1.13) (0.89) (0.99) (0.74) (0.35)
AD
βrx 3.70 2.19 1.82 2.57 2.31 2.25 1.07 1.79
(0.61) (0.58) (0.61) (0.96) (0.77) (0.95) (1.07) (1.32)
RF2 B 24.92 12.96 9.57 14.97 9.96 11.26 0.45 3.95
2
RAD 22.33 9.83 8.69 12.34 12.78 9.98 2.27 5.47
RO 2 29.95 18.80 16.09 24.13 22.24 19.46 12.59 10.86
The table reports estimates, standard errors and R2 of several regressions. In the rst one, I run the usual ft −
st+1 = αrx + βrF B (ft − st ) + εrx,t regression and report the coecient on forward spread and R2 . In the second
specication
PINform∗pa single factor as a simple average of forward spreads across countries and estimate ft − st+1 =
AD
αrx + βrx (i − it ) + εrx,t regression. In the third specication, I regress excess returns on the rst principal
p=1 t
component of eigen-value decomposition of expected returns (formed by regressing excess returns on all interest rate
dierentials and taking the tted values). Only RO 2
of this regression is reported. Standard errors are Hansen and
Hodrick [1980] with an appropriate number of lags.
have uninterpretable negative/positive swings and are susceptible to overtting and multicollinearity
issues.
To test the single factor story formally, I form the single factor using eigen-value decomposition of
expected returns and compare the results with the usual forward spread regression and the regression
with a single factor formed as a simple average of forward spreads across countries. While the single
factor variable formed using the eigen-value decomposition of expected returns seems to perform
better than usual forward-spot dierential (in terms of R2 ), the dierence is not very convincing
The average interest rate dierential (AD) factor Instead of forming an optimal linear
average of them. Such a construction is easily interpretable: it tells us how high home country's
interest rate is relative to the average interest rate in all other countries. This approach was
undertaken also in Lustig et al. [2010b]. Each country is getting the same weight. Potentially, we
may use higher weights for larger countries, i.e. perform something like GDP-weighting.
Estimates of the average interest rate dierential and the usual country-specic dierential
predictive regression are shown in Table 12. It is important that the AD factor is not worse than
portfolio specic dierential on average, which suggests in favor of a single factor structure story.
Table 13 shows the estimates for ∆st+1 regression. The average forward spread factor seems to
perform about the same as simple individual forward spread regression at annual horizon.
To sum up, the average interest rate dierential seems to perform as well as the portfolio-specic
one. However, we know that if ∆s were a random walk, the interest rate dierential would be the
only true predictor of foreign exchange. This suggests in favor of the risk premium story, where
excess returns are related to marginal utility of investors rather than specic characteristics of assets.
33
Table 13: Comparing R2 for ∆st+1
1 2 3 4 5 6 7 8
FB
β∆s -1.96 -1.07 -0.53 -1.80 -1.20 -1.18 0.64 0.24
(0.41) (0.45) (0.46) (1.13) (0.89) (0.99) (0.74) (0.35)
AD
β∆s -2.66 -1.18 -0.81 -1.68 -1.52 -1.26 0.00 -0.58
(0.60) (0.55) (0.64) (0.96) (0.79) (0.96) (1.01) (1.21)
RF2 B 12.69 3.83 1.25 6.77 3.17 3.58 1.46 0.38
2
RAD 13.46 3.14 1.85 5.81 5.95 3.43 -0.01 0.59
RO 2 18.53 10.28 8.38 16.81 16.37 12.48 13.47 7.55
The table reports estimates, standard errors and R2 of several regressions. In the rst one, I run the usual
∆st+1 = α∆s + β∆s FB
(ft − st ) + ε∆s,t regression and report the coecient on forward spread and R2 . In the
second specication P I form a single factor as a simple average of forward spreads across countries and estimate
N
∆st+1 = α∆s + β∆s AD
(i∗p − it ) + ε∆s,t regression. In the third specication, I regress excess returns on the rst
p=1 t
principal component of eigen-value decomposition of expected returns (formed by regressing excess returns on all
interest rate dierentials and taking the tted values). Only RO 2
of this regression is reported. Standard errors are
Hansen and Hodrick [1980] with an appropriate number of lags.
In what follows I will use the average interest rate dierential as a universal home country-specic
The carry-trade risk factor Lustig et al. [2010a] show that the carry-trade risk factor does exist
in the cross-section of foreign exchange. The literature, however, is silent on what is the underlying
The two factor decomposition in foreign exchange markets discussed is similar to the one for
international bond markets: I modeled the bond market risk premium by using two factors as well.
This symmetry in modeling across asset markets makes it easy to compare risk premia. The bond
market's global CP factor seems like a direct equivalent of the foreign exchange market's carry
trade factor. Country-specic bond and foreign exchange factors are related too. In terms of the
risk premium macro story we can expect global risk factors to be related to global business cycles
while country-specic factors to reect country-specic business cycle type of risk (net of global).
If this were true and the bond global risk factor were indeed related to foreign exchange carry
trade factor, it would then follow that the bond GCP factor should predict foreign exchange carry
Table 14 and Figure 13 show that carry trade returns are negatively correlated with the GCP
factor. We know that average return on carry trade is higher, but this return is lower when marginal
utility of investors is high. This has been documented in Lustig and Verdelhan [2007] and Lustig
et al. [2010a]. The result in Table 14, however, says even more: not only the contemporaneous
correlation between the GCP and foreign exchange ex-post returns on carry trade is negative, but
higher GCP today (higher expected excess returns on bonds) predicts relatively lower expected
excess returns on carry trade. Part of this predictability comes from changes in spot rates and
part from interest dierential component, as can be seen in Table 15. This result is quite robust:
34
Figure 13: Carry trade and global CP
0.6
0.5
0.4
0.3
0.2
0.1
−0.1
−0.2
−0.3
−0.4
89 90 91 92 93 94 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09
Bottom black line shows carry trade excess returns. Top red line depicts the global CP factor (scaled).
Table 14: Predicting portfolio returns with global CP and average dierential factors
Carry 1 2 3 4 5 6 7 8
α 0.18 -0.05 -0.03 -0.00 -0.00 -0.02 0.02 0.07 0.13
[2.76] [-1.06] [-0.80] [-0.09] [-0.00] [-0.48] [0.47] [1.53] [2.53]
βGCP -2.85 0.03 0.45 -0.34 -0.14 0.28 0.31 -1.10 -2.82
[-1.73] [0.03] [0.46] [-0.34] [-0.13] [0.33] [0.33] [-0.92] [-1.95]
βAD -2.95 3.01 0.83 1.32 1.47 1.70 1.00 0.36 0.06
[-2.03] [2.70] [0.74] [1.05] [1.14] [1.69] [0.84] [0.27] [0.04]
R2 0.18 0.23 0.02 0.05 0.04 0.07 0.02 0.02 0.08
The table reports estimates of foreign exchange excess returns of various portfolios on two factors: GCP and AD.
Estimates of coecients, t-statistics and R2 for portfolios 1 through 8 are reported in columns numbered 1-8. The
rst column reports the estimates for carry trade strategy (8 minus 1). Standard errors are Hansen and Hodrick
[1980] with an appropriate number of lags.
35
Table 15: Predicting ∆st+1 with global CP and average dierential factors
Carry 1 2 3 4 5 6 7 8
α -0.05 0.00 0.01 -0.02 -0.02 0.01 -0.01 -0.04 -0.05
[-0.83] [0.02] [0.22] [-0.42] [-0.39] [0.22] [-0.38] [-0.86] [-0.93]
βGCP 1.38 0.33 -0.27 0.57 0.45 -0.01 -0.28 0.82 1.71
[0.92] [0.33] [-0.28] [0.55] [0.42] [-0.02] [-0.30] [0.70] [1.24]
βAD 3.78 -2.31 -0.17 -0.54 -0.61 -0.75 0.21 0.95 1.47
[3.16] [-2.17] [-0.15] [-0.44] [-0.47] [-0.74] [0.17] [0.74] [1.01]
R2 0.22 0.17 0.00 0.01 0.01 0.01 0.00 0.03 0.07
The table reports estimates of foreign exchange spot change of various portfolios on two factors: GCP and AD.
Estimates of coecients, t-statistics and R2 for portfolios 1 through 8 are reported in columns numbered 1-8. The
rst column reports the estimates for carry trade strategy (8 minus 1). Standard errors are Hansen and Hodrick
[1980] with an appropriate number of lags.
it holds for both GDP- and equal-weighted GCP factors, as well as a GCP factor constructed by
R2 of the rst portfolio is much higher and it may seem that carry trade results are driven by
this fact; however, the results are robust when choosing other portfolios to form carry trade. For
example, if we choose 8 minus 2, R2 of carry trade is about 15% and the coecients are similar.
Patterns in coecients of portfolio excess returns on two factors are interesting too. Slopes
on the AD factor are the highest for low interest rate countries and close to zero for high ones.
The average risk premia (α) is negative for low interest rate countries, and highly positive for high
interest rate countries. Therefore, investing in low interest rate portfolio delivers negative average
returns (as documented by Lustig et al. [2010a]), but is sensitive to the AD factor in time. The
AD factor hence predicts the time varying risk premium for low interest rate portfolios only. This
means that investing in low interest countries bears signicant amount of the US-specic time-
varying foreign exchange risk. This risk is essentially absent when investing in high interest rate
countries since the movements in US interest rates are relatively small compared to the movements
Time-varying risk premia of high interest rate countries are mostly driven by the carry trade
(GCP) factor. Indeed, slopes of low interest rate countries on the GCP factor are essentially zero,
while high interest rate countries have signicant negative slopes. This is the sense in which high
interest rate countries are riskier: they depreciate in bad times (when GCP is high) and expectedly
so. The average return on high interest rate portfolios (α) is of course signicantly higher than
that of low portfolios as was documented by Lustig et al. [2010a]. Carry trade α is positive and
signicant. It is therefore most protable to invest in carry when GCP is low and US interest rate
is relatively high.
We therefore have two factors that predict foreign exchange in time-series: a country specic
and a global one. First one is the usual one high expected returns when marginal utility is high
36
and people want to consume today. The second one reects the risk associated with involving in
risky carry trade strategies: while the returns on these strategies are higher on average, the carry
trade factor makes higher interest rate countries more risky and prone to devaluations, especially
when the economy is doing poorly. Carry trade is a global factor. By focusing on high/low interest
rate sorted portfolios, we are able to isolate common innovations to the stochastic discount factor
4 The Model
4.1 Long-run risk model
The use of two factors outlined in the paper can be motivated by a long-run risk model similar to
the one in Bansal and Shaliastovich [2009] and Bansal and Yaron [2004]. The model of this type has
been shown (see Bansal et al. [2006]) to be potent in explaining asset returns. In addition, Colacito
et al. [2010] argued that long-run risk model can also explain a wide range of international nance
puzzles, including the high correlation of international stock markets, despite the lack of correlation
in fundamentals.
In what follows I provide a specication of the model that motivates the empirical section of the
paper. The model, however, is neither estimated nor formally tested in this paper. For empirical
support see Bansal et al. [2006], Bansal and Shaliastovich [2009] and Section 4.2.
2 2
σg,t+1 = νg σgt + wg,t+1 (4)
2 2
σx,t+1 = νx σxt + wx,t+1 (5)
Consumption contains a predictable component xt . Both the variance of predictable and id-
iosyncratic components are heteroskedastic. I assume that the consumption and expected growth
innovations ηt+1 and et+1 are standard Normal, while the innovations to volatility processes wg,t+1
and wx,t+1 follow Gamma distribution Γ(σi2 (1 − νi ), σiw
2 ), i = {g, x}.
θ
mt+1 = θlogδ − ∆ct+1 + (θ − 1) rc,t+1 (6)
ψ
37
where the return on consumption rc,t+1 is given by
2 2
pct = A0 + Ax xt + Ags σgt + Axs σxt
2 2
mt+1 = m0 + mx xt + mgs σgt + mxs σxt − λη σgt ηt+1 (7)
where
1
mx =
ψ
1 1
mgs = − γ− (γ − 1)
2 ψ
2
1 1 κ1
mxs = − γ− (γ − 1)
2 ψ 1 − κ1 ρ
(n) 1 (n)
yt = B0 + Bx(n) xt + Bgs
(n) 2 (n) 2
σgt + Bxs σxt
n
1
(n) (n) (n−1) (1)
Et rxt+1 = const + Bxs − νx Bxs − Bxs − λ2e × σxt
2
2
38
Interest rate dierential is
∗(1)
(1) ∗2
yt − yt = Bx(1) (1 − λ) xt + Bgs
(1) 2
σgt − σgt + 1 − λ∗2 Bxs
(1) 2
σxt (8)
Stars (∗) denote country-specic variables. Thus I assume that innovations to short-term con-
sumption growth and its variance are i.i.d. across countries, while the innovations to long-term
consumption component and corresponding variance are perfectly correlated across countries. Ex-
pected consumption growth x∗t+1 of a foreign country loads proportionally on this common inno-
vation, which ultimately makes all xt 's proportional across countries. This assumption reects the
desire to make SDFs highly correlated across countries the condition that must be satised ac-
cording to Brandt et al. [2006]. The motivation to make only long-run components correlated comes
from the view that developed countries have similar expected long-run consumption growth rates
(are cointegrated).
I further assume that ination and expected ination do not respond to short-term news, ϕπg =
ϕzg = 0.
39
(n) 1 (n) (n) (n) 2 (n) 2 (n)
yt,$ = B0,$ + Bx,$ xt + Bgs,$ σgt + Bxs,$ σxt + Bz,$ zt
n
Nominal bond risk premia Expected log nominal bond risk premia is (see Section 6.6.2 for
derivation):
(n) (n) 2 (n−1) (1)
Et rxt+1,$ = const + Bxs,$ − νx Bxs,$ − Bxs,$ σxt (9)
Time varying part of the nominal bond risk premium depends on variance of long-run component
only. This motivates using a common component of CP factors to predict foreign exchange risk
factors is a good proxy for bond risk premium). xt is strongly correlated across countries and is a
global factor.
Lustig et al. [2010a] show that countries load dierentially on the global factor. Under the
assumption that the loadings on the shock in (3) are proportional across countries, parameter λ∗ in
the specication of the model reects exactly this dierential loading on a global factor (I assume
We can now average the interest rate dierential across (developed) countries. Under the as-
sumption that all foreign λ's sum up to unity, the rst term drops out. Furthermore, if the US
ination is highly correlated with the average ination in developed countries, we might expect the
last term to be of a second order importance (this should be checked empirically!). In this case the
average interest rate dierential (AD factor in my empirical part) is a function on two conditional
variances only.
∗(1)
(1)
Et rxFt+1
X,$
= Et st+1 − st + yt − yt
2 2
= Et [− m0 + mx xt − zt + mgs σgt + mxs σxt − t+1
∗(1)
(1)
+ m0 + mx x∗t − zt∗ + mgs σgt
∗2
+ mxs λ2 σxt
2
− ∗t+1 + yt − yt ]
1
∗2
= − mgs − mgs − γ 2 σgt 2
− σgt (1)
− mxs + Bxs 1 − λ2 σxt
2
2
1 2 2 ∗2
1
= γ σgt − σgt + λ2e σxt
2
2 2
40
Foreign exchange risk premium is therefore a linear function of the variance of long-term consump-
tion component and the dierence between short-term variances between two countries. If we invest
in a well diversied portfolio of currencies, the latter term becomes the variance of a home country
factor across developed countries (GCP factors in the empirical part), while the second one can
be estimated by a linear combination of GCP factor and the average interest rate dierential (AD
factor in the empirical part). In other words, we should be able to nd expected excess returns on
a portfolio of currencies by regressing the foreign exchange risk premia on AD and GCP factors.
- conditional variance of an expected consumption growth. If we believe that expected excess bond
return is reasonably well proxied by the Cochrane-Piazzesi factor, this implies that CP factor and
2
σxt are closely linked. While this is a theoretical outcome of my model specication, it might seem
not overly convincing. To explore the relationship between the two, I construct an estimate of
2
σxt
using consumption data and compare it to the CP factor.
2. Regress log consumption growth on a set of predictors (dividend growth, DP, risk free rate,
6. Square the residual of regression in 4 is shown on the rst plot below; predicted part is shown
are some similarities... Correlation is ~20%. Notice hat both estimation techniques are rather ad
hoc and quite noisy, so we cannot expect a perfect correlation here. Remember also that CP factors
41
Figure 14: Volatility of predictable consumption component and CP factor
.0007 .00006
.0006 .00005
.0005 .00004
.0004 .00003
.0003 .00002
.0002 .00001
.0001 .00000
.0000 -.00001
60 65 70 75 80 85 90 95 00 05 10 65 70 75 80 85 90 95 00 05
.00012
.00010 0.14
0.12
.00008
0.1
.00006 0.08
.00004 0.06
0.04
.00002
0.02
.00000 0
-.00002 −0.02
60 65 70 75 80 85 90 95 00 05 10
−0.04
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
DCFU2F
The rst plot shows the conditional variance of expected consumption growth. The bottom left plot
shows estimated value of
2 ;
σxt the last plot shows the CP factor. The top-right plot combines the
two (rescaled).
42
were far from perfectly correlated across countries (although xt 's are perfectly correlated in the
model). All in all, there is some plausibility in this story, but it should be further investigated.
TO BE COMPLETED
5 Conclusions
I have documented new empirical ndings for bond and foreign exchange markets. For bond market,
I have shown that CP factors similar to the US one can also be documented in other countries.
Further, I showed that those CP factors are correlated and a common component can be extracted.
This common component can be interpreted as a global bond factor, which, together with the
country specic CP-factor, can explain bond returns in the the cross-section of countries.
I found a similar two factor structure in the foreign exchange market. The AD factor is related
to the country-specic CP factors and the foreign exchange global factor is related to the GCP
factor. In fact, the GCP factor helps to predict foreign exchange returns. The GCP and AD factors
are both signicant in predicting foreign exchange returns and vary in their importance with the
The ndings in the paper provide evidence in favor of the risk premia story. I show that risk
premia in both markets are strongly linked and should be studied jointly. An interesting extension
of this paper would be to construct an SDF model where time-varying risk premia in bond and
foreign exchange markets are governed by the factors I have documented. The easiest approach
to do this is by extending the Cochrane and Piazzesi [2009] and Koijen et al. [2010] models to an
international setting. I provide my initial thoughts on implementing this exercise in the appendix.
Additionally, pricing the stock market is interesting as well. Ultimately, we would like to link the
The paper points out to several additional areas that are under-researched and might be a
useful continuation of the current work. First, I have shown that the data reported by Central
Banks and other sources are typically smoothed across maturities and this smoothing destroys useful
information. Fama and Bliss [1987] data, on the other hand, seem to preserve the information that
bonds series for foreign countries that use approach similar to that of Fama and Bliss [1987]. Fama
and Bliss [1987] results themselves could be extended to longer maturities. Additionally, there is
some evidence that their approach does not work well in the recent crisis, when the prices of on-the-
run and o-the-run bonds diered substantially. It would then be useful to update their approach
Second, I suggested a way to test whether including additional forward rates in estimating the
CP factor is useful. To accomplish this, I propose to specify the null in the form of a discount factor
model that imposes that CP factor is fully explained by the rst ve forward rates. Under this null,
additional forward rates should be irrelevant and by including them we can construct bounds on
the distribution of R2 of bond predictive regressions. This test diers from a simple χ2 test and is
43
more powerful.
Third, given the predictability and correlations between markets documented, it would be inter-
esting to test the performance of actual trading strategies that combine bond and foreign exchange
investments. Since carry trade risk premia was found to be negatively correlated with GCP factor,
investing in two markets simultaneously may partially hedge the risks. It would then be interesting
44
6 Appendix
6.1 Ane model
6.1.1 Setup
In discrete time specify the dynamics of state variables as
0
Xt+1 = µ + φXt + vt+1 , E vt+1 vt+1 = V
1 0
0 0
Mt+1 = exp −δ0 − δ1 Xt − λt V λt − λt vt+1
2
λt = λ0 + λ1 Xt
n
!
(n) Y
pt = logEt Mt+i
i=1
0
= An + Bn Xt
A0 = 0; B0 = 0
0 0 0
Bn+1 = −δ1 + Bn φ∗
0 1 0
An+1 = −δ0 + An + Bn µ∗ + Bn V Bn
2
φ∗ = φ − V λ 1
µ∗ = µ − V λ 0
For the proof see Cochrane and Piazzesi [2005], Appendix D.1.
0
(n) An B n
yt =− − Xt
n n
45
Forward rates are
1
(n) (n)
Et rxt+1 + σt rxt+1 = covt (rxt+1 , vt+1 ) λt
2
0
= Bn−1 V (λ0 + λ1 Xt )
0 0
= Bn−1 (µ − µ∗ ) + Bn−1 (φ − φ∗ ) Xt
∗
ft − st = logEt Mt+1 − logEt Mt+1
When markets are complete, the following identity links SDFs and exchange rates
∗
logMt+1 − logMt+1 = st+1 − st
46
It then immediately follows that
∗
qt = Et st+1 − st = Et logMt+1 − Et logMt+1
0 0
1 0 0
= − (δ0∗ − δ0 ) − δ1∗ Xt∗ − δ1 Xt − λ∗t V ∗ λ∗t − λt V λt
2
∗ ∗
pt = logEt Mt+1 − logEt Mt+1 − Et logMt+1 − Et logMt+1
1 ∗0 ∗ ∗
0
= λt V λt − λt V λ t
2
0 0 0 0 0 xt
λ λ 0 0 0
levelt
0l 1l
λt = +
0 0 0 0 0
slopet
0 0 0 0 0 curvet
0 0 0 0 0 0 0
λt V λt = λ0 V λ0 + λ0 V λ1 Xt + Xt λ1 V λ0 + Xt λ1 V λ1 Xt
= v22 λ20l + 2λ0l v22 λ1l xt + λ21l v22 x2t
1 ∗0 ∗ ∗ 0
pt = λt V λt − λt V λt
2
1 ∗ ∗2
= v22 λ0l − v22 λ20l
2
+ (λ∗0l v22
∗ ∗ ∗
λ1l xt − λ0l v22 λ1l xt )
1 ∗ ∗2 ∗2
+ v22 λ1l xt − v22 λ21l x2t
2
47
6.4 GCP and country-specic CP specication
6.4.1 Time-varying risk premium
Suppose Xt contains only country-specic yield curve factors. Cochrane and Piazzesi [2009]show
xCP
0 0 0 0 0 0 t
GCP
0 0 0 0 0 0
xt
λt = λ0l + λCP λGCP 0 0 0 levelt
1l 1l
0 0 0 0 0 0 slopet
0 0 0 0 0 0 curvet
Market price of risk depend only on CP and GCP and are earned in compensation to exposure
0 0 0 0 0 0 0
λt V λt = λ0 V λ0 + λ0 V λ1 Xt + Xt λ1 V λ0 + Xt λ1 V λ1 Xt
= v33 λ20l + 2λ0l v33 λCP CP
1l xt + λGCP
1l xGCP
t
2
+v33 xCP CP GCP GCP
t λ1l + xt λ1l
1 ∗0 ∗ ∗ 0
pt = λt V λt − λt V λt
2
1 ∗ ∗2
= v33 λ0l − v33 λ20l
2h i
+ λ∗0l v33
∗
λ∗CP
1l xt
∗CP
+ λ∗GCP
1l xGCP
t − λ0l v33 λCP CP
1l xt + λGCP
1l xGCP
t
1 ∗ ∗CP ∗CP
2 2
+ v33 xt λ1l + xGCP
t λ∗GCP
1l − v33 xCP CP GCP GCP
t λ1l + xt λ1l
2
term is
h i 1 q q
Et rxit+1 i
+ V ar rxt+1 = γzt − δ i ztw δztw + δ i ztw
2
48
√ √ √
= δi δ − δ i ztw + γzt (10)
Lustig et al. [2010b] further argue that this expression does not depend on country-specic factor
zti and hence this calculation can be used as a motivation towards looking for a common factor in
the foreign exchange market.
Bx(n) = ρBx(n−1) − mx
(n) (n−1) 1
Bgs = νg Bgs − mgs − γ 2
2
(n) (n−1) 1 2
Bxs = νx Bxs − mxs − λe + Bx(n−1)
2
(n)
1
(n)
Et rxt+1 + vart rxt+1 = −covt (mt+1 , rxt+1,n )
2
2
= const + c × σxt
(n)
vart rxt+1 = λ2e σxt
2 + const
49
(n) (n−1) (n) (1) (n) (n−1) (1)
rxt+1,$ = pt+1,$ − pt,$ − yt,$ = nyt,$ − (n − 1) yt+1,$ − yt,$
(n) (n) 2 (n)2 (n) (n)
= B0,$ + Bx,$ xt + Bgs,$ σgt,$ + Bxs,$ σxt + Bz,$ zt
(n−1) (n−1) 2 (n−1) 2 (n−1) (n−1) (1)
− B0,$ + Bx,$ xt+1 + Bgs,$ σg,t+1 + Bxs,$ σx,t+1 + Bz,$ zt+1 − yt
(n) (n−1) (1) (n) (n−1) (1) (n−1) (n) (n−1) (1)
= B0,$ − B0,$ − B0,$ + Bx,$ − ρBx,$ − Bx,$ − Bz,$ αx xt + Bz,$ − αz Bz,$ − Bz,$ zt + B
(n) (n−1) 2 (1) (n−1) (n−1) (n−1) (n−1) (n
+ Bxs,$ − νx Bxs,$ − Bxs,$ σxt − Bx,$ + Bz,$ ϕzx σxt et+1 − Bgs,$ wg,t+1 − Bxs,$ wx,t+1 − Bz,$
Substituting these into the formula for excess returns (and assuming ϕπg = ϕzg = 0) yields
(n) (n) 2 (n−1) (1)
rxt+1,$ = const + Bxs,$ − νx Bxs,$ − Bxs,$ σxt −
(n−1) (n−1) (n−1) (n−1) (n−1) (n−1)
− Bx,$ + Bz,$ ϕzx σxt et+1 − Bgs,$ wg,t+1 − Bxs,$ wx,t+1 − Bz,$ ϕzg σgt ηt+1 − Bz,$ σz ξz,t+1
50
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