Asset Prices and Exchange Rates

Anna Pavlova and Roberto Rigobon

No 4322-03, Working papers from Massachusetts Institute of Technology (MIT), Sloan School of Management

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 contagion. The foreign exchange market serves as a propagation channel from one stock market to the other. The model identifies interconnections among 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. Moreover, the factors we extract from daily data on stock indexes and exchange rates explain a sizable fraction of the variation in a number of macroeconomic variables, and the estimated signs on the factors are consistent with our model's implications. We also derive agents' portfolio holdings 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: Asset Pricing; Exchange Rate; Contagion; International Finance; Open Economy Macroeconomics (search for similar items in EconPapers)
Date: 2004-11-30
New Economics Papers: this item is included in nep-fin, nep-fmk, nep-ifn and nep-mac
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (9)

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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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