Asset Prices and Exchange Rates

Roberto Rigobon and Anna Pavlova

No 579, Econometric Society 2004 North American Winter Meetings from Econometric Society

Abstract: This paper develops a simple two-country, two-good model, in which the real exchange rate, stock and bond prices are jointly determined. The model predicts that stock market prices are correlated internationally even though their dividend processes are independent, providing a theoretical argument in favor of financial markets contagion. The foreign exchange market serves as a propagation channel from one stock market to the other. The model identifies interconnections between stock, bond and foreign exchange markets and characterizes their joint dynamics as a three factor model. Contemporaneous responses of each market to changes in the factors are shown to have unambiguous signs. These implications enjoy strong empirical support. Estimation of various versions of the model reveals that most of the signs predicted by the model indeed obtain in the data, and the point estimates are in line with the implications of our theory. Furthermore, the uncovered interest rate parity relationship has a risk premium term in our model, shown to be volatile. We also derive agents' portfolio holdings and and identify economic environments under which they exhibit a home bias, and demonstrate that an international CAPM obtaining in our model has two additional factors

Keywords: Exchange rate; asset prices; contagion; international macroeconomics; international finance (search for similar items in EconPapers)
JEL-codes: F31 F36 (search for similar items in EconPapers)
Date: 2004-08-11
New Economics Papers: this item is included in nep-ifn
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Citations: View citations in EconPapers (14)

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Related works:
Journal Article: Asset Prices and Exchange Rates (2007)
Working Paper: Asset Prices and Exchange Rates (2004)
Working Paper: Asset Prices and Exchange Rates (2003)
Working Paper: Asset Prices and Exchange Rates (2003)
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Persistent link: https://EconPapers.repec.org/RePEc:ecm:nawm04:579

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