Abstract
The aim of this paper is to create a general affine framework that would allow the pricing of nominal and inflation-linked bonds in an international setting and that would help to explain term structure movements in terms of macroeconomic shocks, exchange rates or policy-related factors. The contribution of this paper is that it enlarges the multifactor affine Daffie-Kan framework to model affine joint domestic and foreign nominal and real term structures, domestic and foreign price levels, and nominal and real exchange rates. We assume that the bond prices are influenced by the multivariate factor whose price process is driven by both a multidimensional Wiener process and a general marked point process. We provide necessary and sufficient conditions on the factor dynamics, domestic and foreign short rates and/or exchange rate and price level dynamics in order to obtain jointly affine domestic and foreign real and nominal term structures and real exchange rate. We investigate if the general affine framework is consistent with the empirical evidence supporting the purchasing power parity (PPP) hypothesis; that is, we find necessary and sufficient conditions for the real exchange rate in the affine framework to be mean stationary. As compared to previous studies we include in the set of observables inflation-linked domestic and foreign bonds as well as nominal exchange rate and price levels. Thus we estimate the international ATS model for the joint domestic and foreign nominal and inflation-linked bonds, including nominal exchange rate and price levels in the set of observables. As a practical application of this international model we construct a "real exchange rate" option and demonstrate how to price it. This derivative can be introduced and used by investors to hedge exchange rate and inflation risks.