The Global Factor Structure of Exchange Rates

Sofonias A. Korsaye, Fabio Trojani and Andrea Vedolin
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Sofonias A. Korsaye: University of Geneva - Geneva Finance Research Institute (GFRI); Swiss Finance Institute
Fabio Trojani: Swiss Finance Institute; University of Geneva
Andrea Vedolin: Boston University - Department of Finance & Economics

No 20-107, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

Abstract: We provide a model-free framework to study the global factor structure of exchange rates. To this end, we propose a new methodology to estimate international stochastic discount factors (SDFs) that jointly price cross-sections of international assets, such as stocks, bonds, and currencies, in the presence of frictions. We theoretically establish a two-factor representation for the cross-section of international SDFs, consisting of one global and one local factor, which is independent of the currency denomination. We show that our two-factor specification prices a large cross-section of international asset returns, not just in- but also out-of-sample with R2s of up to 80%.

Keywords: International asset pricing; stochastic discount factor; factor models; financial frictions; market segmentation; incomplete markets; capital flows; regularization; lasso (search for similar items in EconPapers)
JEL-codes: F31 G15 (search for similar items in EconPapers)
Pages: 53 pages
Date: 2020-10
New Economics Papers: this item is included in nep-ifn and nep-opm
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Citations: View citations in EconPapers (6)

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Persistent link: https://EconPapers.repec.org/RePEc:chf:rpseri:rp20107

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