Asset Prices and Exchange Rates

Anna Pavlova and Roberto Rigobon

No 9834, NBER Working Papers from National Bureau of Economic Research, Inc

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 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 in our model, shown to be volatile. 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.

JEL-codes: F31 F36 (search for similar items in EconPapers)
Date: 2003-07
New Economics Papers: this item is included in nep-fin and nep-ifn
Note: AP IFM
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (29)

Published as Anna Pavlova & Roberto Rigobon, 2007. "Asset Prices and Exchange Rates," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 20(4), pages 1139-1180.

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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 (2004)
Working Paper: Asset Prices and Exchange Rates (2003)
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