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Common Factors and Local Factors: Implications for Term Structures and Exchange Rates

Published online by Cambridge University Press:  06 April 2009

Dong-Hyun Ahn
Dong-Hyun Ahn
Affiliation:
[email protected], School of Economics, Seoul National University, Seoul, Korea and Kenan-Flagler Business School, University of North Carolina-Chapel Hill, CB 3490, McColl Building, Chapel Hill, NC 27599–3490.
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Abstract

This paper studies a multi-factor, two-country term structure and exchange rate model when a diversification effect for an international bond portfolio is expected. It shows that the diversification gain calls upon certain restrictions on the process of the stochastic discount factor in a factor-structured economy. Existence of local factors is shown to be a necessary condition for the gains from investing in foreign bonds. Further, the exchange rate risk premia are shown to be a function of the differentials of the risk premia of the factors in bond returns. Empirical results reveal the tendency for investors to respond sensitively to rare shocks, which is shown to be a potential solution to the forward premium puzzle.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 39 , Issue 1 , March 2004 , pp. 69 - 102
Copyright
Copyright © School of Business Administration, University of Washington 2004

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