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Why Are Exchange Rates So Smooth? A Heterogeneous Portfolio Explanation

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

No 214, 2017 Meeting Papers from Society for Economic Dynamics

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 heterogeneous household portfolios. A large fraction of households either hold low risk portfolios and/or do not adjust their portfolio optimally, 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.

Date: 2017
New Economics Papers: this item is included in nep-dge, nep-ifn and nep-opm
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