NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Affine Models of Currency Pricing

David Backus, Silverio Foresi, Chris Telmer

NBER Working Paper No. 5623
Issued in June 1996
NBER Program(s):   AP   IFM

Perhaps the most puzzling feature of currency prices is the tendency for high interest rate currencies to appreciate, when the expectations hypothesis suggests the reverse. Some have attributed this forward premium anomaly to a time-varying risk premium, but theory has been largely unsuccessful in producing a risk premium with the requisite properties. We characterize the risk premium in a general arbitrage-free setting and describe the features a theory must have to account for the anomaly. In affine models, the anomaly requires either that state variables have asymmetric effects on state prices in different currencies or that we abandon the common requirement that interest rates be strictly positive.

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Document Object Identifier (DOI): 10.3386/w5623

Published: Journal of Finance, Volume 56: Issue 1 February 2001

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