International Stochastic Discount Factors and Stochastic Correlation
Keywords
We propose a Wishart Affine Stochastic Correlation (WASC) model for the joint dynamics of the SDF in an international economy; We derive exchange rate dynamics and a quasi-closed-form solution for currency option pricing; This solution includes Heston’s stochastic volatility model as a special case; We benchmark our approach to a vector-based model inspired by Bakshi; Carr; Wu (2008; JFE); We estimate both models for the US; Europe; and Japan; Empirically; the WASC model is more robust with respect to the estimation period; In contrast to the benchmark model; estimated risk sharing indices seem to reflect the Euro crisis (2011/12) in the WASC model; Moreover; the explanatory power of filtered Sharpe ratios for stock market returns and volatilities is higher (both in- and out-of-sample)