Exchange Rate and Risk Premium Conversion on Interest Rate markets

ABSTRACT This paper investigates common factors that jointly determine bond returns across-countries. We study how risk factors deriving bond prices influences exchange rates and we test if parameters of bond price process are fundamental in specifying exchange rate process. We use an arbitrage free international stochastic discount factor (SDF) framework in order to analyse interaction between bond prices and exchange rate process. We show that risk premia are different through countries and exchange rate serve to convert currency-specific risk premia across countries. JEL Classification: C33, F31, G12, G15. Keywords: Term structure; Common factors; Exchange rate; Bond returns I. INTRODUCTION Bond portfolios investors diversify, generally, their portfolio by investing in foreign bonds. The management of an international bond portfolio requires a model that evaluates bond prices of different maturities in diverse countries. Several studies (1) report that premiums of different countries have, generally, similar evolution, which imply the existence of a limited number of common factors that derive the joint yield curve across countries. In order to optimally diversify their assets, portfolio managers are primarily interested in mechanisms that influence premiums and the degree of heterogeneity of premium variations. This involves determination of the number and the nature of common sources of variation for each bond. Despite their crucial role in international portfolio management, the covariance between premiums across countries and the number of underlining common factors are rarely investigated in the theory. The asset pricing model of Ross (1976) shows that common variation of asset returns can be expressed as linear function of a number of factors. But this model doesn't specify the number and the characteristics of these factors. Despite the ultimate success of this theory, it appears unable to explain high correlations between bond yields across the maturity spectrum and across countries and to identify their common sources of variation. Solnik (1983) extended the arbitrage pricing theory to an international framework. He shows that if asset returns, expressed on an enumerative money, follow a linear factor model, then the expected return vector are perfectly identified by the principal factor vector. Ikeda (1991) suggests that direct extension of the asset pricing theory to an international context is counter intuitive since exchange risk might induce an additional factor in the arbitrage process on financial markets. The key element of these advancements is to suppose that the generation process of returns is specified on an enumerative currency. Under this precision, exchange risk of assets returns is automatically diversified when constructing a risk free portfolio. Our study is related to Knez, Litterman and Scheinkman (1994) and Litterman and Scheinkman (1991) who estimate a model for short-term US monetary market returns and long-term USA government bond returns, respectively. Knez et al. (1994) propose a four-factor model. The first two factors correspond to movement in the level and the slope of the term structure, while the other two factors describe credit risk difference of the different money market instruments. Litterman and Scheinkman (1991) use the principal compound analysis and show that US bond returns are mainly determined by three factors, which correspond to level movement, slope and curvature movement in the term structure. This paper extends these two studies by jointly analysing bond returns in four countries, namely the USA, Germany, UK and Japan. The joint analysis of interest rate term structures is particularly useful in studying potential international diversification and international bond portfolios management. In this spirit we model a cross-country covariance matrix including (1) bond return variance of each country, (2) covariance of domestic bond returns across maturities, and (3) covariance of bond return across-countries. …