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Asset Prices and Exchange Rates

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Author Info
Anna Pavlova
Roberto Rigobon

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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.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 9834.

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Date of creation: Jul 2003
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Handle: RePEc:nbr:nberwo:9834

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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.:
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Full references

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.)

  1. Fabrizio Perri & Jonathan Heathcote, 2007. "The International Diversification Puzzle Is Not as Bad as You Think," Working Papers 2007-3, University of Minnesota, Department of Economics, revised 08 Oct 2007. [Downloadable!]
    Other versions:
  2. Antonio Diez de los Rios, 2007. "Exchange Rate Regimes, Globalisation, and the Cost of Capital in Emerging Markets," Working Papers 07-29, Bank of Canada. [Downloadable!]
    Other versions:
  3. Basak, Suleyman & Pavlova, Anna, 2004. "A Dynamic Model with Import Quota Constraints," Working papers 4230-02, Massachusetts Institute of Technology (MIT), Sloan School of Management. [Downloadable!]
  4. Harald Hau & Helene Rey, 2004. "Can Portfolio Rebalancing Explain the Dynamics of Equity Returns, Equity Flows, and Exchange Rates?," American Economic Review, American Economic Association, vol. 94(2), pages 126-133, May. [Downloadable!] (restricted)
    Other versions:
  5. Elizaveta Krylova & Lorenzo Cappiello & Roberto A. De Santis, 2005. "Explaining exchange rate dynamics - the uncovered equity return parity condition," Working Paper Series 529, European Central Bank. [Downloadable!]
  6. Emmanuel Farhi & Xavier Gabaix, 2008. "Rare Disasters and Exchange Rates," NBER Working Papers 13805, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  7. Pierre-Olivier Gourinchas, 2006. "The Research Agenda: Pierre-Olivier Gourinchas on Global Imbalances and Financial Factors," EconomicDynamics Newsletter, Review of Economic Dynamics, vol. 7(2), April. [Downloadable!]
  8. Basak, Suleyman & Pavlova, Anna, 2004. "Monopoly Power and the Firm’s Valuation:," Working papers 4234-01, Massachusetts Institute of Technology (MIT), Sloan School of Management. [Downloadable!]
  9. Philip R. Lane & G Milesi-Feretti, 2004. "Financial Globalization and Exchange Rates," CEP Discussion Papers dp0662, Centre for Economic Performance, LSE. [Downloadable!]
    Other versions:
  10. Coeurdacier, Nicolas & Kollmann, Robert & Martin, Philippe, 2007. "International Portfolios with Supply, Demand and Redistributive Shocks," CEPR Discussion Papers 6482, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
    Other versions:
  11. Cedric Tille, 2005. "Financial integration and the wealth effect of exchange rate fluctuations," Staff Reports 226, Federal Reserve Bank of New York. [Downloadable!]
    Other versions:
  12. Pavlova, Anna & Rigobon, Roberto, 2005. "Wealth Transfers, Contagion and Portfolio Constraints," CEPR Discussion Papers 5117, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
    Other versions:
  13. Fabio Ghironi & Jaewoo Lee & Alessandro Rebucci, 2007. "The Valuation Channel of External Adjustment," NBER Working Papers 12937, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  14. Christian Bauer & Sebastian Horlemann, 2006. "Modeling the Term Structure of Exchange Rate Expectations," Macroeconomics termstructure-bauer-horle, Department of Economics, Economics I, Bayreuth University. [Downloadable!]
  15. John. Cochrane & Francis Longstaff & Pedro Santa-Clara, 2003. "Two Trees: Asset Price Dynamics Induced By Market Clearing," University of California at Los Angeles, Anderson Graduate School of Management 1248, Anderson Graduate School of Management, UCLA. [Downloadable!]
    Other versions:
  16. Basak, Suleyman, 2004. "Asset Prices with Heterogenous Beliefs," CEPR Discussion Papers 4256, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
  17. Devereux, Michael B & Saito, Makoto, 2006. "A Portfolio Theory of International Capital Flows," CEPR Discussion Papers 5746, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
    Other versions:
  18. John Y. Campbell & Karine Serfaty-de Medeiros & Luis M. Viceira, 2007. "Global Currency Hedging," NBER Working Papers 13088, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  19. Kollmann, Robert, 2006. "International Portfolio Equilibrium and the Current Account," CEPR Discussion Papers 5512, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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