Why Are Exchange Rates So Smooth? A Segmented Asset Markets Explanation

YiLi Chien, Hanno Lustig and Kanda Naknoi
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Hanno Lustig: Stanford University

Research Papers from Stanford University, Graduate School of Business

Abstract: Empirical work on asset prices suggests that pricing kernels have to be almost perfectly correlated across countries. If they are not, real exchange rates are too smooth to be consistent with high Sharpe ratios in asset markets. However, the cross-country correlation of macro fundamentals is far from perfect. We reconcile these empirical facts in a two-country stochastic growth model with segmented markets. A large fraction of households either do not participate in the equity market or hold few equities, and these households drive down the cross-country correlation in aggregate consumption. Only a small fraction of households participate in international risk sharing by frequently trading domestic and foreign equities. These active traders are the marginal investors, who impute the almost perfect correlation in pricing kernels. In our calibrated economy, we show that this mechanism can quantitatively account for the excess smoothness of exchange rates in the presence of highly volatile stochastic discount factors.

JEL-codes: F10 F31 G12 G15 (search for similar items in EconPapers)
Date: 2015-11
New Economics Papers: this item is included in nep-dge and nep-opm
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Citations: View citations in EconPapers (6)

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