Modeling Foreign Exchange Risk Premium in Armenia. Emerging Markets Finance and Trade, forthcoming

This paper applies stochastic discount factor methodology to modeling foreign ex-change risk premium in Armenia. Our analysis is performed using weekly data on foreign and domestic currency deposits, which coexist in the Armenian banking system. This coexistence implies elimination of the cross-country risks and trans-action costs, leaving the pure foreign exchange risk. It is shown that there exists a systematic time-varying risk premium, which increases with maturity. Using two-currency affine term structure and GARCH-in-mean models, we find that central bank’s foreign exchange market interventions and ratio of deposit volumes are sig-nificant factors affecting public expectations about foreign exchange fluctuations. We also find that foreign exchange risk premium accounts for the largest part of interest differential. When accounting for economic and institutional differences our results can be extended to other countries