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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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F31 - International Economics - - International Finance - - - Foreign Exchange
F36 - International Economics - - International Finance - - - Financial Aspects of Economic Integration

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