Research On The Exchange Rate Risk Premium Of RMB/NTD Based On Stochastic Discount Factor

The economic and trade exchanges between mainland and Taiwan has more than 30 years of history. In recent years, the trade volume expanded quickly. But unlike the cross-strait economic cooperation, the financial cooperation develop slowly. With the signing of ECFA and MOU on Cross-Strait Currency Settlement, the cross-strait currency settlement mechanism formally established. This indicates that cross-strait currency cooperation has entered a new stage of development. In nowdays, the exchange rate of RMB/NTD is priced through USD. There is no direct pricing mechanism between RMB and NTD which become the question need to be solved on establishing the cross-strait currency settlement mechanism. In this article, we regard the exchange rate between RMB and NTD as an asset. And we use stochastic discount factor method based on the theory of assets pricing to study the exchange rate risk between RMB and NTD. This paper will provide basis for two-way direct exchange of RMB and NTD.In this article we use no arbitrage pricing method and stochastic discount factor method to study the relationship among spot rate, stochastic discount factor and forward exchange rate. And then put forward a formula used in exchange rate pricing. Further we separate exchange forward premium into expected discount rate and risk premium, and construct a forward exchange rate risk premium model. We select benchmark interest rate and CPI index of mainland and Taiwan as the main influencing factors of RMB/NTD exchange rate, and express the expect discount rate and forward risk premium with the stochastic discount factor including the influencing factors.We select the benchmark interest rate and CPI index data of mainland and Taiwan from January 2003 to June 2012, and use RMB/USD NDF and NTD/USD NDF to obtain RMB/NTD NDF as the forward exchange rate. Then we use GMM method to estimate the parameter of expect discount rate model and risk premium model and expand the parameter to the term structure of interest rates. We found that the influence of benchmark interest rate differentials and CPI index differentials on risk premium gradually increases with the period increases. Since the forward exchange rate risk mainly caused by the uncertain part risk premium, we establish VAR equation and take impulse response test of risk premium. We found that the shock on interest rate differentials and CPI index differentials will influence the risk premium, but the influence weaken with the time increase. Last we conduct stress tests on the forward exchange rate risk premium to study what degree will the influencing factor change impact the risk premium. We construct stress test model based on the risk premium model and set base scenario and reference scenario based on historical data. Last we propose some recommendations for RMB and NTD exchange rate risk management.