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Abstract
Many foreign-bond portfolio managers use weighted average to aggregate portfolio duration. The underlying assumptions of this practice are that foreign and domestic interest rate shifts are perfectly correlated and that exchange rate changes are trivial. Prior literature does not provide an applicable solution to this challenge. The authors present an ex ante two-factor duration model that accounts for both foreign interest rate and exchange rate exposures and can be implemented using empirical estimation. The authors calibrate their model and test it out of sample for five currencies. The results show that their model significantly improves price change predictability relative to commonly used single-factor models.
TOPICS: Fixed income and structured finance, analysis of individual factors/risk premia, statistical methods
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