Review of Quanlitative Finance and Accounting, 2 (1992): 17-31

© 1992 Kluwer Academic Publishers, Boston. Manufactured in The Nelhedand~.

The Impact of Jump Risks on Nominal Interest Rates

and Foreign Exchange Rates

CHANG MO AI-[N
Graduate School of Business Administration, Michigan State University, MI 48824
HOWARD E, THOMPSON
Graduate School of Business, University of P~sconsin~Madison, Madison, W[ 53706

Abstract, This article investigates the relationship between Me nominal interest rate and inflation and ~so the
forward exchange rate under a general specification of the underlying processes governing the foreign exchange
rate. There are three distinct risks that affect the relation between the real rate of interest and the nominal ram,
namely, consuraption risk, diffusion risk, and the existence of jump risks of inflation. Jump risks lower the nominal
interest rate because of jump hedging of a nominal bond. The forward exchange rate depends on the expected
depreciation of the domestic currency as welt a~ ~ e w three risks. As ~ domestic jump risks increase, the domestic
nominal interest rate decreases and the forward exchange rate decreases.

Key words: j~tmp risks, nominal interest rate, foreign exchange rate

1. Introduction

Empirical analysis within the last decade has documented discontinuous sample paths for
certain financial variables. Jarrow and Rosenfeld (1984) reported that U.S. stock returns
follow jump-diffusions. Akgiray and Booth (1988), Tucker and Pond (1988), lorion (1988),
and Tucker (1991) have demonstrated that foreign exchange rares could also be described
by jump-diffusions.1With v,~ll-developed international capital markets, a connection bet~en
the two sets of observations seems Likely.Furthermore, it seems likely that jump-diffusions
may be present in other financial series, such as interest rates. The hypothesis that these
observations may be explained by exogenous jumps in price levels in domestic economies
is not an easy one to dismiss, since inflation jumps may be caused by actions of sovereign
governments.
The effect of inflation on interest rates was the subject of the famous Fisher relation
(1930), when he argued that the nominal interest rate should be the sum of the real interest
rate and the expected inflation rate. Subsequent research by Fisher (1975), Cox, Ingersoll,
and Ross (1981, I985b), Benninga and Protopapadakis (1983), and LeRoy (1984) has shown
that, under uncertainty, the simple Fisher relationship would not hold. In all these studies,
the nature of the probability distribution of the rate of inflation changes the impact of infla-
tion on interest rates. None of these studies analyzed inflation as a jump-diffusion. Thus
the way in which jumps affect nominal interest rates is an open issue.
International asset-pricing models have been developed by Solnik (1974), Grauer, Litzen-
berger, and Stehle (1976), Fama and Father (1979), Hodrick (1979), Stulz (1981), and Adler
18 CHANG MO AHN AND H.E. THOMPSON

and Dumas (1983), among others. In none of these models is a state variable characterized
by a jump-diffusion process. Thus the theoretical impact of jump-diffusions on a number
of interesting asset-pricing issues, such as exchange rates, has not been formally studied.
The apparent existence of jumps in financial time series, the likely source of these jumps
within the domestic economies being price levels, the apparent transmission of jumps through
the exchange markets between countries, and the apparent lack of a theoretical model positing
exogenous state variables as jump-processes motivate this article.
Our purpose is to trace the impact of jumps in state variables as they are transmitted
through the international financial markets. We do this by first ignoring the international
capital markets and focusing on the effects of jump risks on nominal interest rates. We
show that an additional modification to the Fisher relationship is needed. We then extend
the analysis to an international setting and show that jump risks of inflation affect the nomi-
nal interest rate differentials and the forward and spot exchange rates. Our theoretical model
serves as a first try at explaining the presence of the jumps that have been found in empiri-
cal analysis.
Section 2 introduces a simple general-equilibrium model in which the price level is char-
acterized as a jump-diffusion process. The model developed in section 2 serves as the basis
for the remainder of the article. In section 3, we derive the relationship between the real
and nominal interest rate, showing the existence of a jump-risk component of the nominal
interest rate. We extend the model into the international setting in section 4, where we
show a nominal interest rate differential and a nominal international asset-pricing model
resulting from the jump-diffusion as descriptions of inflation rates. Section 5 summarizes
the results of the article.

2. A simple general-equilibrium modal for the domestic economy

In this section, we consider an economy similar to that used by Cox, Ingersoll, and Ross
(1985a). The economy has a single good and a large number of infinitely lived consumers,
identical in their endowments and preferences. Consumers have homogeneous beIiefs about
production technologies and state variables. Each consumer seeks to maximize his/her life-
time expected utility, given by

(1)

where E 0 is a conditional expectation operator based on the consumer's information set

at time 0, p is the rate of time impatience, C(t) denotes the consumption rate at time t,
and u(.) is a yon Neumann-Morgenstern utility function. The utility function u is strictly
concave, increasing, and twice differentiable. We assume that u(0) -- 0 and u'(0) = oo
to insure interior solutions.
We simply assume that the first state variable is the price, P, of the single good, which is
assumed to follow a jump-diffusion process expressed in the stochastic differential equation 2

dP :- P{#p(P) - (~(P)}dt + Poe(P)dZ + PQ(P)dY, (2)

THE IMPACT OF JUMP RISKS 19

where

~tp(P) is the expected rate of the percentage change in inflation,

tre(P ) is the (N + K + 1) x 1 diffusion vector of inflation such that aeo b is the

instantaneous variance of the percentage change in inflation,

Z is an (N + K + l) vector of independent Wiener processes,

Q(P) is a scalar that translates jumps in Y into the corresponding jumps in P,

Y is a Poisson process with the intensity parameter, 7r, which is the probability of
a jump,

Q(P) is the expected value of the jump magnitude of the percentage change in infla-
tion, i.e., Eg[Q(P)g], where Eg is the expectation operator with respect to the jump
amplitude g.

The jump amplitude, g, is assumed to be independent of Y and Z. Note that/~e includes

the expected rate of inflation from the diffusion process and also from the jump process.
Following Cox, Ingersoll, and Ross (1985b), we examine a real economy where money
would serve no purpose. Even though inflation has no effect on the underlying real equilib-
rium, the nominal interest rate would be affected by inflation. In order to highlight the
effect of jump risks of inflation, we assume that the underlying process for all state variables
and production technologies except the price level follow diffusion processes. Thus the
only jumps are in the price level.
We assume that there are K additional state variables whose dynamics are determined
by the stochastic differential equation

dX = I~(X)dt + S(X)dZ (3)

where

~(X) is a K x 1 vector of the expected drifts,

S(X) is a K x (N + K + 1) diffusion matrix such that SS' is positive definite.

The economy has Ndistinct technologies for production of the single good. The (N x 1)
real output vector, dq, is determined by a system of the stochastic differential equations,

dO. = Zqo,(X)dt - ]qG(X)~ (4)

where
20 CHANG MO AHN AND H.E. THOMPSON

cz(X) is an N x 1 vector of the expected rates of real return on the output,

G(X) is an N × (N + K + 1) diffusion matrix such that G G ' is positive definite,

Iq is an N × N diagonal matrix whose ith element is the ith element of q,

The vector Z is as previously defined.

Since the price level does not affect the underlying real equilibrium, o~(X), G(X), v(X),
and S(X) would be independent of P.
The (3/× 1) nominal output vector(,/) is the inner product of the price(P) and the (N × 1)
real output vector(q). From equations (2) and (4) and Ito's lemma, the dynamics of the
nominal output vector, dr, are determined by a system of the stochastic differential equations,~

d~ -- I~{o~ + (¢e - Q)IN + Ga]~}dt + I~{G + a e l u } d Z + i ~ Q l u a Y , (5)

where

I T is an N × N diagonal matrix whose ith element is the ith element of ~,

1N is an N x 1 vector of ones,

a + ~I, + Go~ is the nominal expected return.

All consumers are assumed to be competitive price takers. They have equal access to
production technologies, and continuous investment and trading are available without trans-
action costs.
There is a competitive market for a default-free discount indexed bond, B, whose dynamics
are given by

aS -- r*(X)dt + dP
--if- -- {~*(X) + I~1, - O}dr + oedZ + Odr, (6)

where r* is the real interest rate, which will be determined later, and r* + /~e is the ex-
pected nominal return on the indexed bond. There is also a competitive market for a con-
tingent claim, D, whose dynamics are given by

dD
D - {BD - ~o}dt + oDdZ + eDdY, (7)

where/3o is the nominal expected rate of return on the claim, eD is a (N + K + 1) × 1

diffusion vector, eD is an (/7 + K + 1) x 1 vector, and ~D is the expected value of the
jump amplitude of D.
At each instant, each consumer will allocate his or her nominal wealth among investments
in the production technologies, indexed bonds, nominal bonds, contingent claims, and
THE IMPACT OF JUMP RISKS 21

consumption(C). Let a(t) be the vector of the proportion of nominal wealth invested in
each of the N production technologies, and let b(t) and (5(0 be the number of the indexed
bonds and the contingent claims in the consumer's portfolio, respectively. Define W(t) to
be the consumer's nominal wealth at the time t. The amount invested in nominal bonds
is W(1 - a'lt¢) - bB - 61).
Each consumer solves the problem given by

max Eo e x p ( - o t ) u ( C ( t ) , t)d (8)

a,b,C

subject to

dW(t) = f3wdt + awdZ + e w d Y (8a)

and

w(o) = Wo, (Sb)

where

~w = W a ' { a - rlN + (l~,o -- Q)IN + Go'/~} + r W + bB{r" + i~t, - O~ - r}

+ 3D{[3o - eo - r} - PC, (8c)

aw = W a ' { G + o e l u } + bBap + 6Doo, (Sd)

ew = WQ + bBQ + 6Deo, (Be)

and r is the nominal interest rate. Note that this formulation of the model posits an investor
maximizing utility that depends on real consumption (7, subject to a constraint on wealth
that is in nominal terms. Given that equations (8a)-(8e) involve nominal variables W,, B,
D, and the price level P, intuition suggests that the real interest rate will be independent
of P, leaving the only impact of P on the nominal rate.
We assume that a solution exists and that the control functions, a(W, P, X, t), b(W, P, X, 0,
6(W,, P, X, t) and C(W, P, X, t) and the nominal indirect utility function,

J(W(t), P(t), X(t)) = max

{a,h,8,c}
Et
El" t
e x p ( - p ( s - t))u(C(t), t) (9)

satisfy the Bellman equation,

0 =- max [u(C) - pJ + ~wJw + (l/2)awO{Jww + Powa~JwP + P(#p - Q.)Jp

{.,o,~,c}

+ (1/2)I~aea].Jee + vE~[J(W + ewg, P + PQg, X) - J(W, P. X)I + PSai,1px

+ ~,x]x + owsTwx + (t/2) Y', ~ J~xCov(X,, Xj)l. (to)

i 1
22 CHANG MO AHN AND H.E, THOMPSON

The first-order conditions for the consumer's optimization are

Uc - PJw = 0 (11)

{o~ - rlN + (#e -- Q)IN + Ga~}Jw + {G + o,~IN}O&J~w + {G + aelr~}o~JweP

+ (G + trelN)S'Jwx + ~rEg[Jw(W + ewg, P + PQg, X)Q1Ng] = 0, (12)

{r" + IZe - Q - r}Jw + opO~Jww + Pvpo[Jwe + aeS'Jwx

+ rEg[Jw(W + ewg, P + PQg, X)Qg] = 0, (13)

{80 - eo - r}Jw + ono~vJww + PtrDtr~J~w + aDS'Jw-x

+ rEg,[Jw(W + ewg, P + PQg, X)eDg] = 0 (14)

Differences of the above first-order conditions under jump-diffusion processes from those
under diffusion processes are explained in detail in Alan and Thompson (1988).
Since real consumption is a function of real wealth, we have4

ot/aP rv
otto-----w = - < o (15)

and

Jv~e W = Jw~, (16)

Jw -f-~w P + 1

where C denotes optimal real consumption.

It is well known that no trading is Pareto optimal in an identical consumer economy,
and so, following Cox, Ingersoll, and Ross (1985a), we have the equilibrium conditions,

a'l N = 1, (17a)

b = O, (17b)

~$ = O, (17c)

where t~ is an N × 1 vector denoting the optimal proportions invested in technologies and

b is the number of indexed bonds.
We follow the usual rational:expectations approach, assuming that each consumer solves
his or her optimization problem taking a, r*, and r as given. Then t~, r * and r are deler-
mined in the model by the equilibrium conditions.
THE IMPACT OF IUMP RISKS 23

3. Nominal interest rate in the domestic economy

In this section, we will examine the relationship between the nominal interest rate and the
real interest rate. Our results are intuitively appealing: 1) the real interest rate is unaffected
by inflation, 2) the nominal interest rate is affected by inflation, 3) the jump risk of infla-
tion is priced in the nominal rate, 4) the jump risk tends to lower the nominal rate, 5) the
nominal rate may be greater or less than the real rate, depending on the relationship between
expected inflation and its variability and consumption and jump hedging. We will also show
how our result differs from the previous literature (e.g., Benninga and Protopapadakis, 1983).
Theorem 1 provides the equilibrium nominal interest rate and the equilibrium real inter-
est rate?

Theorem 1. The equilibrium nominal interest rate is given by

r = h'e~ - ~'GG'& r WJww] Jwx

+ 7rEgIJw(W+ ewg'P + "Qg'X) - JI~W'P'X) ]

Jw(W, P, X) Qg (18)

and the equilibrium real interest rate is given by

r* = • 'or - ?,'GG'?, I - WJww]

_j - &'GS' ( - Jwx
--f-~wI . (19)

To see that the real rate is unaffected by inflation, let real wealth be W'* ~- W/P and
the indirect utility function in terms of real wealth be I(W~, X, t) - J(W, P, X, t). Thus
we have Jw = I~/P, Jww -- lw*w*/l~ and Jwx -- I~,~/P.Using equations (17a) through (17c)
and (18), we can show that the equilibrium real interest rate is

~., = Od '(fiG') I 1N _ (_Iw.x/I~)SG,(GG,)-t liv - ( - W'lw,~/Iw,) (20)

I ~ G G ' ) I IN

Since or(X), G(X), t~(X), and S(X) are independent of P as is I and its derivative, the equi-
librium real interest rate is not affected by inflation. The optimal investment and consump-
tion policies (i.e., h and C) are not affected either. This result is no surprise.
The relationship between the real interest rate and the nominal interest rate is, however,
affected by inflation, since the nominal interest rate is critically affected by inflation.
Theorem 1 allows us to examine this relationship.
Using equation (16) and the market equilibrium conditions, we have

a"Go~- WJww] + oeS, I_7._.~wl

Jg/x ___ol, a ~ _ U c c ] (21,
J uc)"
24 CHANG MO AHN AND H.E. THOMPSON

Equation (21) shows that the sum of the covariances of inflation with the market portfolio
and the state variables can be collapsed into the covariance between inflation and consump-
tion. This result is due to Breeden (1979) and will be used as one of the adjustments that
must be made to the real rate to obtain the nominal rate.
From Theorem 1 and equation (21), we have the following relationship between the real
and nominal interest rates.

Theorem 2. The relation between the nominal and real interest rates is given by
(-
r -- r* + ~ze - apa~ I - UCCl - opob
Uc .)

+ rEg F JW(W+ ewg, P + PQg, X ) - Jw(W, P, X)

(22)
L Jw(W, P, X) Qg.J "

Theorem 2 shows the adjustments that must be made to the Fisher relation when uncer-
tainty is present. Under certainty, the Fisher relation asserts that the nominal interest rate
is the sum of the real interest rate and the inflation rate. Adding uncertainty, equation (22)
shows that there are three distinct additional terms needed to establish the relationship be-
tween the real and the nominal rates.
The first term, (aeob(-Ucc/Uc)), is related to the consumption hedging of a nominal
bond.~ The second term is related to the variability of inflation (aea~o) coming from the
Jonson inequality (see Benninga and Protopapadakis, 1983). These two terms appear in
previous papers on inflation, such as Fisher (1975), Benninga and Protopapadakis (1983),
and Cox, Ingersoll, and Ross (1985b).
The last term of the right-hand side of equation (22) comes from jump risks of inflation.
This term has not been discussed in the literature of inflation. It is well known that the
asset price is determined by the relationship between marginal utility of wealth (i.e., the
benchmark portfolio) and the asset's payoff. Adding a jump process to the inflation process
results in the jump process being priced in nominal assets, since marginal utility of nominal
wealth includes jump risks, and jump risks of marginal utility are correlated with jump
risks of the nominal assets.
Using equation (11), we can rewrite the last term of equation (22) as

I Q2g2 ]
~Eg 1 + Qg ' (23)

where 1 + Qg is positive from the positivity of marginal utility of wealth. Thus, the third
term is negative, and will tend to lower the nominal interest rate. This result holds, since
a nominal bond delivers the same payoff regardless of the occurrence of jumps; consequently,
jump hedging of a nominal bond is appreciated by consumers, and they would demand
a smaller risk premium in its presence.
In sum, whether the nominal interest rate is greater than the real interest rate depends
on whether the expected inflation rate, tZp, of a nominal bend overrides the effect from
variability of inflation and the consumption hedging and jump hedging of a nominal bond.
THE IMPACTOF JUMP RISKS 25

For example, when expected inflation is high and predictable, the nominal rate would exceed
the real rate. On the other hand, where expected inflation is low but 1) uncertainty of the
extent of inflation is high, 2) consumption is highly correlated with prices, and 3) large
jumps in inflation are likely, we could find the nominal rate falling short of the real rate.
This result can be seen intuitively by recognizing that substantial uncertainties in the price
level should cause an increase in the demand for nominal bonds as opposed to index bonds,
which will produce a lower expected utility. Given that the demand is higher, the price
will rise and the nominal interest rate will fall. For nominal rates to be lower than the
real rates would be an unusual occurrence, taking place only when the expectation of infla-
tion was near zero but predictability of price levels was nearly impossible.
In general, jumps in price levels add to price uncertainty and thus act in part like the
variability effect and in part like the consumption hedging effect, since the impact is trans-
mitted through the marginal indirect utility function. The effect of jump, however, is dis-
tinct from the two other effects because of its origin in a Poisson process as opposed to
a Brownlan-motion process.

4. International capital markets and jumps in inflation

The jumps in exchange rates can also be explained by jumps in price levels in countries.
We examine an economy of L countries where international trading of securities and the
commodity is unrestricted and cosfless. Each country is similar to the one assumed in sec-
tion 2 in terms of identical consumers and a single commodity. Each consumer is assumed
to maximize his/her lifetime expected utility given by equation (1). In the open, frictionless
international capital markets, each consumer and the commodity are homogeneous across
countries. Our model is similar to those of Grauer, Litzenberger, and Stehle (1976), Fama
and Farber (1979), and Stulz 0981), all of which assume fully integrated international capital
markets. It is similar in spirit to Stulz (1984), who developed a general-equilibrium inter-
national asset-pricing model that endogenizes the stochastic processes of the asset prices.7
However, our model is unique in that jump-diffusion processes for exchange rates result
from jumps in inflation in the domestic economies. The theoretical model is consistent
with the results reported by empirical studies.8
The dynamics of the price index of the ith country are given by

d P ' -- P ' { I / p ( P ' ) - Q.,(Pi)}dt + P i g e ( P ~ ) d Z + PZQ~(Pi) d Y i -- 1 . . . L (24)

where superscript i denotes country i. Equation (24) is identical to equation (2) except
for superscripts. We assume that a jump in any country affects all countries' price processes
as a result of international tradeY We use the Lth country's currency as a measurement
currency. The dynamics of the nominal output from N production technologies, expressed
in the measurement currency, becomes identical to equation (5), if superscript L is added.
Purchasing power parity is assumed to always hold exactly. If S0 denotes the exchange
rate that is the price in thejth country's currency of one unit of the ith country's currency,
we must have that

s,j- = PJ/P", (25)

26 CHANG MO AHN AND H,E. THOMPSON

From equations (24) and (25) and Ito's lemma, the dynamics of the exchange rate are given by

dsv_
- {Orso - esv}dt + asvdZ + esodY, (26)

where

i + - -Q-~
Ceso = #~ - tz~ - Q.s + Q, - oJpa~' + #po~p + 7rEg [ QJg Q~g ] ' (26a)

as,, = aJe - de, (26b)

Q~ - ai
es,j = 1 + Q, ' (26c)

~s, = ~rEgI Q l g - Q~g ] (26d)

1 + Q,g '

and ~s,j is the expected value of the percentage change in the exchange rate and ~Sr is the
expected value of the jump magnitude of the percentage change. In equations (26a)-(26d),
jump-diffusion processes for the dynamics of the exchange rate come from jump-diffusion
processes for the dynamics of the price levels• If none of the price levels follows jump-
diffusion processes, the exchange rate cannot ~llo.,vjump-diffusion processes. Furthermore,
if Qi = Q.J for Pi and ~ , then there would be no impact of the jump at all on the exchange
rate. However, empirical evidence that the exchange rate follows jump-diffusion processes
implies that it is reasonable to assume jump-diffusion processes for the dynamics of the
price level within the countries and that the impacts on countries are different.
There is a competitive market for default-free discount nominal and indexed bonds in
each country. The dynamics of the nominal bond issued in country i, measured in the meas-
urement currency, are given by

-ff(dB' = ri(X)d t + dSiZsit. = {r ~ + as~ _ ~s,L}dt + asitdZ + es,Ldy

Q QJ dY

i = 1 .. L - 1 (27)

where B i denotes the measurement currency price of a default-free discount nominal bond
issued in country i, and P is country i's nominal interest rate. The dynamics of the indexed
bond issued in country i, expressed in the measurement currency, are given by

dB*i - r*dt + d(SiLPi) (28)

B*i SiLPi '
THE IMPACTOF JUMP RISKS 27

where S,LPi = PL from equation (25) and r* is the real interest rate, which will be shown
in equation (33) identical across countries. Thus the dynamics are identical to equation (6).
Compared to the domestic model in section 2, each consumer has additional investment
sources from foreign-currency denominated nominal bonds. Thus the amounts of foreign-
currency denominated nominal bonds are additional choice variables to each consumer.
Except for this aspect, the formulation of the problem is identical to the one in section 2.
The additional first-order condition for the consumer's optimization related to these nominal
bonds is

{r' + t~s¢ - gs~t - rL}Jw + astzak/Jww + Os,tor~e,PLJwpL + os¢S'Jwx

+ rEg IJ w( W + ewg ' p, + p,Q,g, .., pL + pLQLg, X) QLg

T "+"- "Q-~
Qig 1 - - 0 ,

i - - 1 .. L - 1. (29)

Imposing the equilibrium conditions similar to equations (17a) through (17c) and using
equations (11) and (16), we can rewrite equation (29) to yield the nominal interest rate dif-
ferential across countries given by

rL r' I - Ucc~ os~o~ - OsiL~, - 7rE~ I 1 +QLg

QLg esicgI " (30)
-- = °¢S~ -- tt¢ J

The nominal interest rate differential depends on the expected rate of depreciation of the
measurement currency relative to currency i and three factors,to
From the interest parity, the forward premium for currency i, f,., which is the percentage
difference between the forward exchange rate and the spot exchange rate, must be identical
to the nominal interest rate differential, i.e., f, = r L - rl. 11 Thus, equation (30) has impli-
cations for the forward exchange rate. There are three factors that make the forward ex-
change rate different from the unbiased estimator of the spot exchange rate. The first term
is the covariance between changes in the exchange rate and changes in the world aggregate
real consumption rate. It lowers the forward exchange rate. The second term is the covariance
between changes in the exchange rate and changes in the price level. This term also lowers
the forward exchange rate. These two terms appear and are qualitatively identical to those
in Hodrick (1979), Stulz (1981), an Adler and Dumas (1983).
The third term appears because the exchange rate contains jumps. As discussed in section
3, the foreign bond is priced by the relationship between its payoff and marginal utility
of world aggregate wealth (i.e., the benchmark portfolio). The foreign bond contains jump
risks from the exchange rate that are correlated with jump risks of the benchmark port-
folio. Thus, jump risks of the foreign bond are priced so that they affect the foreign nominal
interest rate, the nominal interest rate differential, and the forward premium.
Note that -QLg/(1 + QLg) is the percentage jump change in marginal utility of (world
aggregate) wealth. Thus, this third term is the expected value of the product of the percent-
age jump change in marginal utility of wealth and the percentage jump change in the exchange
rate. The higher the correlation between jump changes in the marginal utility of wealth
28 CHANG MO AHN AND H.E. THOMPSON

and jump changes in the exchange rate, the higher the forward exchange rate. This currency
has jump increases in value when the world aggregate wealth has jump decreases. The
currency enhances jump hedging, and this effect raises the forward exchange rate.
Examining the last term of equation (30) in detail, we show that jump hedging of the
domestic (foreign) bond decreases (increases) the forward premium. From equation (26c),
the last term can be rewritten as

- rcEg I 1 +
QLg
QLg QLg
T "+"- "Q-~
Q~g 1 " (31)

If the price level of country i does not jump components, equation (31) becomes identical
to equation (23). Thus, since country L is interpreted as the domestic country, jump hedg-
ing from the domestic nominal bond lowers the domestic nominal interest rate and conse-
quently lowers the forward exchange rate. Rearranging equation (31) gives

~rEa I 1 Qrg
+ Qjg + 1 +QzgQLg 1 " (32)

If the jump component of the price level of country i increases, the forward exchange rate
increases. This result holds, since jump hedging from the nominal bond from country i
increases and lowers the nomirml interest rate of country i. Consequently, the forward ex-
change rate must increase as shown in equation (30).1~
The nominal interest rate differential could be expressed in terms of the expected infla-
tion differential. Using equations (30) and (26a) through (26d), we can express the nominal
interest rate differential as

rL _ ri = #~ _ Ucc~ @o+ - @ @ ' - TEg 1 + Qtg

uc d

(33)
uc _3 1 + Q,g "

The nominal interest rate differential depends on the expected inflation differential as well
as the differentials in other three factors. These factors are the consumption hedging of
a nominal bond, variability of inflation, and jump hedging of a nominal bond. Applying
equation (21) for country L and i and finding the nominal interest rate differential gives
an identical equation to equation (33), which assures the same equilibrium real interest
rate across countries. This result follows from the assumption of fully integrated interna-
tional capital markets.

5. Conclusions

This article was motivated by empirical observations that stock-price return and foreign
exchange rate series tend to exhibit jumps, and yet theoretical literature tended to ignore
THE IMPACT OF JUMP RISKS 29

the possibility of jumps. We have attempted a rectification of this apparent omission by

deriving an international asset-pricing model driven by jumps in inflation rates within coun-
tries. Our analysis was in nominal terms.
We find general conclusions that arise under jump-diffusion process. First, there are
three factors that make the Fisher relation more complicated than originally supposed. Two
of them have been mentioned in the literature, namely, the consumption hedging of a nominal
bond and the variability of inflation. The third factor comes from jump hedging of a nominal
bond, which lowers the nominal interest rate. This factor has not been recognized in the
literature. Intuitively, the presence of a jump just adds to the variability and thus has the
same sign as the variability previously analyzed.
Second, in the international asset-pricing model, the required nominal rate of return on
an asset also depends on three factors, including the jump risk of the foreign exchange
rate. Forward exchange rates are critically affected by these factors. The jump risk of the
foreign bond from the foreign exchange rate is priced, since the jump risk is correlated
with marginal utility of the world aggregate wealth. Jump hedging of the domestic (foreign)
bond decreases the domestic (foreign) nominal interest rate and decreases (increases) the
forward exchange rate.
Our analysis suggests that the jump risk of inflation can have a significant impact on
nominal interest rates, nominal asset prices, and exchange rates. It appears that the subject
is worth studying. Our model contains some restrictive assumptions. In particular, it includes
homogeneous consumers, as do most models of asset pricing. We need to develop a general-
equilibrium model under heterogeneous consumers. Specially, this extension in the inter-
national finance is desirable, considering that consumers may have different tastes across
national boundaries.

Notes

1. The mixed jump-diffusion process is a time-independent process. There are other recent empirical observations
by Milhoj (1987), Hsieh (1988)*, and Lastmpes (1989) that show a high degree of statistical dependence for
currency returns for which ARCH models tend to fit the data more satisfactorily than a variety of other models.
These models do not test jump-diffusions. A recem paper by Akgiray and Booth (1989) using Canadian foreign
exchange rates also suggest dependency. Even though allowing time-dependent processes has recently been
suggested by empirical observations, we leave this for a future study and coasider only a jump-diffusion
process throughout this article.
2. Our general equilibrium model with a single good and identical consumers, in an international setting, re-
quires price jumps in order to show exchange rate jumps, since the model implies fully integrated interna-
tional capital markets and purchasing-power parity. The assumption of fully integrated international capital
markets and purchasing-power parity may be relaxed. A more complex model, with international market
imperfections such as the existence of capital and exchange controls and nontraded goods, endogenously deter-
mines purchasing-power parity deviations, which may include jumps. Such a model can permit exchange
rate jumps without price jumps.
3. Stochastic differential equations used in this article are discussed in detail in Kushner (1967) or Gihman and
Skorohod (1972). Let dx = c(x, Odt + A(x, t)dZ + B(x, OdE Let F(x, t) he twice continuously differentiable
in (x, t). Then by Ito's lemma,

dF - [Fr(x, 0 + Fr(x, t)c(x, t) + (l/2)tr(Fax(x, t)A{x, t)A(x, t)')ldr

+ F,(x, t)A(s, OdZ + [F(x + B(x, t), t) - F(x, t)ldY.

30 CHANG MO AHN AND H.E. THOMPSON

4. Equations 05) and (16) are originally derived by Fisher (1975).

5. Proofs for theorems of this article are available from the authors upon request.
6, Even though the price level does not affect the underlying real equilibrium, its change can be statistically
correlated with changes in real wealth and consumption, as pointed out in Cox, Ingersoll, and Ross (1985b).
If inflation is positively correlated with consumption, the real payoff of a nominal bond is negatively corre-
lated with consumption. Thus. a nominal bond provides a consumption hedging, which lowers the nominal
interest rate.
7. A limitation of these models is the assumption of identical consumers. Allowing heterogeneous consumers
in a general equilibrium model would be an improvement, but would involve a considerable complication.
8. Park, Ahn, and Fujihara 0990) have examined optimal hedged portfolios when the foreign exchanges rate
follows a mixed jump-diffusion process. Their paper examines the effect of the jump risk on the optimal
investment decisions for an individual. Their analysis does not require an equilibrium as does the present
article, which examines the effect of jump risk on international asset pricing.
9. A multidimensional jump process can be introduced straightforwardly, A multidimensional jump process
would allow us to specify the source of inflatinnary jumps and to analyze how decisions by one government
affect the nominal rates in other countries. Here, we use the one-dimensional jump process for simplicity,
since the incorporation of multiple dimensions would complicate the notation and tend to obscure the result
that we obtain.
10. Equation (30) is an implication that can be tested with the data. Dally data are preferred to be used in testing
over monthly data, since jumps am less spectacular in the relatively long-lerm data series because of averaging
out (see ]arrow and Roseafeid, 1984). In that respect, exchange rate jumps may poorly correspond to price
jumps on monthly data.
11. Under no arbitrage, the imerest parity must hotd regardless of the specification of The stochastic process.
12. We can see from equation (32) that if QL = Qi. the last term of equation (30) drops out. In this case, the
jump has no impact on the nominsl interest rate differential and the forward interest rate, since the jump
from country i exactly offsets the jump from country L such that there is no impact of the jump on the ex-
change rate.

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