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Why Are Exchange Rates So Smooth? A Segmented Asset Markets Explanation

Author

Listed:
  • Chien, YiLi

    (Federal Reserve Bank of Saint Louis)

  • Lustig, Hanno

    (Stanford University)

  • Naknoi, Kanda

    (University of CT)

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 segmented markets. A large fraction of households either do not participate in the equity market or hold few equities, 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.

Suggested Citation

  • Chien, YiLi & Lustig, Hanno & Naknoi, Kanda, 2015. "Why Are Exchange Rates So Smooth? A Segmented Asset Markets Explanation," Research Papers 3414, Stanford University, Graduate School of Business.
    • Handle: RePEc:ecl:stabus:3414
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    File URL: http://www.gsb.stanford.edu/gsb-cmis/gsb-cmis-download-auth/415351
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    Citations

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    Cited by:

    1. Djeutem, Edouard & Dunbar, Geoffrey R., 2022. "Uncovered return parity: Equity returns and currency returns," Journal of International Money and Finance, Elsevier, vol. 128(C).
    2. Hassan, Ramin & Loualiche, Erik & Pecora, Alexandre R. & Ward, Colin, 2023. "International trade and the risk in bilateral exchange rates," Journal of Financial Economics, Elsevier, vol. 150(2).
    3. Lustig, Hanno & Verdelhan, Adrien, 2016. "Does Incomplete Spanning in International Financial Markets Help to Explain Exchange Rates?," Research Papers 3412, Stanford University, Graduate School of Business.
    4. Zhengyang Jiang, 2019. "US Fiscal Cycle and the Dollar," 2019 Meeting Papers 667, Society for Economic Dynamics.
    5. Anella Munro, 2016. "Bond premia, monetary policy and exchange rate dynamics," Reserve Bank of New Zealand Discussion Paper Series DP2016/11, Reserve Bank of New Zealand.

    More about this item

    JEL classification:

    • F10 - International Economics - - Trade - - - General
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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