What do financial markets say about the exchange rate?

Mikhail Chernov, Valentin Haddad and Oleg Itskhoki

No 19071, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: Financial markets play two roles with implications for the exchange rate: they accommodate risk sharing and act as a source of shocks. In prevailing theories, these roles are seen as mutually exclusive and individually face challenges in explaining exchange rate dynamics. However, we demonstrate that this is not necessarily the case. We develop an analytical framework that characterizes the link between exchange rates and finance across all conceivable market structures. Our findings indicate that full market segmentation is not necessary for financial shocks to explain exchange rates. Moreover, financial markets can accommodate a significant extent of international risk sharing without leading to the classic exchange rate puzzles. We identify plausible market structures where both roles coexist, addressing challenges faced when examined separately.

JEL-codes: E44 F31 G15 (search for similar items in EconPapers)
Date: 2024-05
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Working Paper: What do Financial Markets say about the Exchange Rate? (2024)
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