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Volatility, intermediaries, and exchange rates

Xiang Fang and Yang Liu ()

Journal of Financial Economics, 2021, vol. 141, issue 1, 217-233

Abstract: We propose and estimate a quantitative model of exchange rates in which participants in the foreign exchange market are intermediaries subject to value-at-risk (VaR) constraints. Higher volatility translates into tighter VaR constraints, and intermediaries require higher returns to hold foreign assets. Therefore, the foreign currency is expected to appreciate. The model quantitatively resolves the Backus–Smith puzzle, the forward premium puzzle, and the exchange rate volatility puzzle and explains deviations from the covered interest rate parity. Moreover, the model implies both contemporaneous and predictive relations between proxies of leverage constraint tightness and exchange rates. These implications are supported in the data.

Keywords: Volatility; Financial intermediaries; Exchange rates; Currency returns; Value at Risk (search for similar items in EconPapers)
JEL-codes: F31 G15 G20 (search for similar items in EconPapers)
Date: 2021
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DOI: 10.1016/j.jfineco.2020.05.010

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