Abstract: Existing research has yet to identify a risk premium that reconciles the empirical properties of exchange rate returns with prices of other assets in financial markets. One such empirical property that has eluded pricing models is the forward premium anomaly: the tendency for currencies with high interest rates to appreciate against currencies with lower interest rates. I examine the forward premium anomaly through the lens of an arbitrage-free model for the exchange rate and term structures of interest rates in two currencies. I use the model to examine two sets of currency pairs: the U.S. Dollar and British Pound, and the U.S. Dollar and Euro. Previous papers in this literature have failed to match exchange rate volatility in their models, which is a vital component of the risk premium in exchange rate returns. I estimate the model with the joint time-series of swap rates in both relevant currencies, exchange rate returns, and prices of at-the-money exchange rate options. I include option prices because they are highly sensitive to the level of volatility and to the pricing of volatility risk. When I use options to estimate the model, it successfully captures both exchange rate volatility and the term structure of interest rates in both currencies. Using simulated data, I show that the model also replicates the empirical findings in Fama (1984) and is consistent with the forward premium anomaly.
Abstract: There is strong empirical evidence that long-term interest rates contain a time-varying risk premium. Interest rate options may contain information about this risk premium because their prices are sensitive to the volatility and market prices of the risk factors that drive interest rates. We use the time series of swap rates and interest rate cap prices to estimate dynamic term structure models. The risk premiums that are estimated using option prices are better able to predict excess returns for long-term swaps over short-term swaps, both in- and out-of-sample. In contrast to previous literature, the most succesful models for predicting excess returns have risk factors with stochastic volatility. We also show that the models that are estimated using option prices are consistent with the failure of the expectations hypothesis.
Abstract: The most recently issued, on-the-run, Treasuries are extremely liquid and frequently trade at a premium in both the cash and repo, or financing, markets. Previous research suggests that these premiums reflect demand from buy-and-hold investors who value the superior liquidity of these securities and are reluctant to lend them in the repo market. We find evidence for an alternative explanation: premiums in the repo market appear more closely related to market intermediaries' demand to borrow and short-sell on-the-run Treasuries in order to hedge interest rate risk in their inventories.