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.
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9834.
Length: Date of creation: Jul 2003 Date of revision: Publication status: 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. Handle: RePEc:nbr:nberwo:9834
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Pavlova, Anna & Rigobon, Roberto, 2003.
"Asset Prices and Exchange Rates,"
Working papers
4322-03, Massachusetts Institute of Technology (MIT), Sloan School of Management.
[Downloadable!]
Pavlova, Anna & Rigobon, Roberto, 2004.
"Asset Prices and Exchange Rates,"
Working papers
4322-03, Massachusetts Institute of Technology (MIT), Sloan School of Management.
[Downloadable!]
Find related papers by JEL classification: F31 - International Economics - - International Finance - - - Foreign Exchange F36 - International Economics - - International Finance - - - Financial Aspects of Economic Integration
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References listed on IDEAS Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
Barry Eichengreen & Andrew K. Rose & Charles Wyplosz, 1996.
"Contagious Currency Crises,"
NBER Working Papers
5681, National Bureau of Economic Research, Inc.
[Downloadable!] (restricted)
Other versions:
Cass, David & Pavlova, Anna, 2003.
"On Trees And Logs,"
Working papers
4233-02, Massachusetts Institute of Technology (MIT), Sloan School of Management.
[Downloadable!]
Other versions:
Pavlova, Anna & Cass, David, 2002.
"On Trees and Logs,"
Working papers
4233-02, Massachusetts Institute of Technology (MIT), Sloan School of Management.
[Downloadable!]
David Cass & Anna Pavlova, .
"On Trees and Logs,"
CARESS Working Papres
00-01, University of Pennsylvania Center for Analytic Research and Economics in the Social Sciences.
[Downloadable!]
Reinhart, Carmen & Kaminsky, Graciela & Vegh, Carlos, 2002.
"Two Hundred Years of Contagion,"
MPRA Paper
13229, University Library of Munich, Germany.
[Downloadable!]
Cited by: (explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.) This item has more than 25 citations. To prevent cluttering this page, these citations are listed on a separate page.