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Macroeconomic fundamentals and the exchange rate dynamics: A no-arbitrage macro-finance approach

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  • Yin, Weiwei
  • Li, Junye

Abstract

In this paper, we propose an arbitrage-free international macro-finance model that links the exchange rate dynamics to macroeconomic fundamentals. Jointly using data on exchange rates, yields of zero-coupon bonds, and macroeconomic variables of the US and the Euro area, we find a close link between macroeconomic fundamentals and the exchange rate dynamics. The model-implied monthly exchange rate changes can explain about 57% variation of the observed data. The macroeconomic innovations can help capture large variation of exchange rate changes. Robustness checks show that the results also hold for other major exchange rates.

Suggested Citation

  • Yin, Weiwei & Li, Junye, 2014. "Macroeconomic fundamentals and the exchange rate dynamics: A no-arbitrage macro-finance approach," Journal of International Money and Finance, Elsevier, vol. 41(C), pages 46-64.
    • Handle: RePEc:eee:jimfin:v:41:y:2014:i:c:p:46-64
    DOI: 10.1016/j.jimonfin.2013.10.004
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    More about this item

    Keywords

    Exchange rate dynamics; Macroeconomic fundamentals; Stochastic discount factor; Term structure of interest rates; Unscented Kalman filter;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models

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