Quadratic Term Structure Models with Jumps in Incomplete Currency Markets

Download or read book Quadratic Term Structure Models with Jumps in Incomplete Currency Markets written by and published by . This book was released on 2004 with total page pages. Available in PDF, EPUB and Kindle. Book excerpt: We propose a multi-currency quadratic term structure model that allows for several sources of market incompleteness. A new feature of the model is the jump-quadratic dynamics of the exchange rates that simultaneously generate greater flexibility in the time-varying risk premium and excessive currency volatility. Our model empirically outperforms the complete market quadratic and affine multi-currency diffusion models. It accounts for the forward premium anomaly with reasonable market price of risks. The market incompleteness consists of idiosyncratic diffusion-like innovations and jump discontinuities. We find that the jumps dominate the variations in the currency returns and produce most of the excessive currency volatility.