Stochastic risk premiums, stochastic skewness in currency options, and stochastic discount factors in international economies

We develop models of stochastic discount factors in international economies that produce stochastic risk premiums and stochastic skewness in currency options. We estimate the models using time-series returns and option prices on three currency pairs that form a triangular relation. Estimation shows that the average risk premium in Japan is larger than that in the US or the UK, the global risk premium is more persistent and volatile than the country-specific risk premiums, and investors respond differently to different shocks. We also identify high-frequency jumps in each see front matter r 2007 Elsevier B.V. All rights reserved. .jfineco.2006.12.001 k G. William Schwert (the editor), Nasir Afaf, Doron Avramov, David Backus, David Bates, Charles hen, Mike Chernov, Peter Christoffersen, Pat Dennis, Emanuel Derman, Joost Driessen, Jin-chuan Dupire, Rob Engle, Stephen Figlewski, Rene Garcia, Brian Healy, Steve Heston, Haitao Li, Kris Jarrow, Frank de Jong, Paul Kupiec, Pete Kyle, Nengjiu Ju, Nikunj Kapadia, Hosssein Kazemi, Jun oewenstein, Dilip Madan, Pascal Maenhout, Stewart Mayhew, Nour Meddahi, Ludovic Phalippou, obon, John Ryan, Ken Singleton, Harvey Stein, Arun Verma, Frank Zhang, and seminar at the 2005 Annual Derivatives Securities and Risk Management Conference at the Federal Deposit rporation, Bloomberg LP, Courant Institute, 2005 Financial Econometrics Conference in Montreal, f Maryland, University of Massachusetts at Amherst, 2005 University of Virginia Conference on Derivatives, and Asset Pricing, 2005 Empirical Asset Pricing Retreat in Amsterdam, and 2005 ance Association meetings in Portland for comments. We are especially grateful for the detailed n anonymous referee. Any remaining errors are ours. Bakshi acknowledges partial support from the t given to the Smith Business School at Maryland. nding author. Tel.: +1646 312 3509; fax: +1 646 312 3451. dress: [email protected] (L. Wu). this article as: Bakshi, G., et al., Stochastic risk premiums, stochastic skewness in currency options, stic discount factors in.... Journal of Financial Economics (2007), doi:10.1016/j.jfineco.2006.12.001