Implications of Asset Market Data for Equilibrium Models of Exchange Rates

Zhengyang Jiang, Arvind Krishnamurthy and Hanno Lustig
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Zhengyang Jiang: Northwestern U
Arvind Krishnamurthy: Stanford U
Hanno Lustig: Stanford U

Research Papers from Stanford University, Graduate School of Business

Abstract: We characterize the relation between exchange rates and their macroeconomic funda- mentals without committing to a specific model of preferences, endowment or menu of traded assets. When investors can trade home and foreign currency risk-free bonds, the exchange rate (conditionally) appreciates in states of the world that are worse for home investors than foreign investors. This prediction is at odds with the empirical evidence and can only be overturned (unconditionally) if the deviations from U.I.P. are large and exchange rates are highly predictable. Without bond Euler equation wedges, it is impossible to match the empirical exchange rate cyclicality (the Backus-Smith puzzle) and the deviations from U.I.P. (the Fama puzzle) as well as the lack of predictability (the Meese-Rogoff puzzle). To relax this trade-off, we need Euler equation wedges consistent with a home currency bias, home bond convenience yields or financial repression.

Date: 2023-11
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