Abstract: We characterize the relation between exchange rates and their macroeconomic fundamentals without committing to a specific model of preferences, endowment or menu of traded assets. When investors can trade home and foreign currency risk-free bonds, the exchange rate (conditionally) appreciates in states of the world that are worse for home investors than foreign investors. This prediction is at odds with the empirical evidence and can only be overturned (unconditionally) if the deviations from U.I.P. are large and exchange rates are highly predictable. Without bond Euler equation wedges, it is impossible to match the empirical exchange rate cyclicality (the Backus-Smith puzzle) and the deviations from U.I.P. (the Fama puzzle) as well as the lack of predictability (the Meese-Rogoff puzzle). To relax this trade-off, we need Euler equation wedges consistent with a home currency bias, home bond convenience yields, or financial repression.
Discussant: Oleg Itskhoki, University of California-Los Angeles
Thomas Mertens, Federal Reserve Bank of San Francisco
Abstract: Canonical long-run risk and habit models reconcile high equity premia with smooth risk-free rates by inducing an inverse functional relationship between the variance and the mean of the stochastic discount factor. We show this highly successful resolution to closed-economy asset pricing puzzles is fundamentally problematic when applied to open economies with complete markets: It requires that differences in currency returns arise almost exclusively from predictable appreciations, not from interest rate differentials. In the data, by contrast, exchange rates are largely unpredictable and currency returns differ because interest rates differ widely across currencies. We show that no complete-markets model with canonical long-run risk and habit preferences can match this fact. We argue this tension between canonical asset pricing and international macroeconomic models is a key reason why researchers have struggled to reconcile the observed behavior of exchange rates, interest rates, and capital flows across countries. The lack of such a unifying model is a major impediment to understanding the effect of risk premia on international markets.
Discussant: Valentin Haddad, University of California-Los Angeles
Xiaoliang Wang, Hong Kong University of Science and Technology
Abstract: U.S. dollar exchange rates are predictable by U.S. bond yields in the weeks around monetary policy announcements, rising following an increase in yields. In the post-zero-lower-bound period, the information in the “path” factor that reflects forward guidance surprises is impounded in the exchange rate over five days following the FOMC meeting. Using data on currency order flows, we trace out the channel for the delayed adjustment of exchange rates to monetary news. Foreign exchange dealers increase dollar purchases immediately following a monetary tightening, while funds and non-bank financial institutions do so with a 3-5 day delay; banks serve as liquidity providers by supplying dollars. These flows explain much of the exchange rate predictability that we document. Decomposing the daily change of exchange rate into news about future interest rate differentials, excess returns, and inflation, we find that a surprise future tightening of U.S. monetary policy raises all components: expected future returns, interest rate differentials, and long-run differential between U.S. and foreign inflation.
Goetz von Peter, Bank for International Settlements
Abstract: How do exchange rates affect the asset allocation of bond portfolio investors? Using detailed security-level holdings, we find that euro area-based investors systematically shed sovereign bonds as the dollar strengthens, confirming the role of the dollar as a global risk factor even for euro-based investors. More distinctively, they also shed local currency bonds when the euro strengthens, due to currency mismatches on their own balance sheets. There is no such effect for foreign currency bonds of the same sovereign issuers. These findings are consistent with a Value-at-Risk portfolio choice model that brings out separate roles for local, foreign and reference currencies.
Discussant: Fabricius Somogyi, Northeastern University
