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Why are exchange rates so smooth? A household finance explanation

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  • Chien, YiLi
  • Lustig, Hanno
  • Naknoi, Kanda

Abstract

Empirical moments of asset prices and exchange rates imply that pricing kernels are almost perfectly correlated across countries. Otherwise, observed real exchange rates would be too smooth for high Sharpe ratios. However, the cross-country correlation among macro fundamentals is weak. We reconcile these facts in a two-country stochastic growth model with heterogeneous households and a home bias in consumption. In our model, only a small fraction of households trade domestic and foreign equities. We show that this mechanism can quantitatively account for the smoothness of exchange rates in the presence of volatile pricing kernels and weakly correlated macro fundamentals.

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  • Chien, YiLi & Lustig, Hanno & Naknoi, Kanda, 2020. "Why are exchange rates so smooth? A household finance explanation," Journal of Monetary Economics, Elsevier, vol. 112(C), pages 129-144.
  • Handle: RePEc:eee:moneco:v:112:y:2020:i:c:p:129-144
    DOI: 10.1016/j.jmoneco.2019.02.003
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    Cited by:

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    2. Adrien Verdelhan & Hanno Lustig, 2016. "Does Incomplete Spanning in International Financial Markets Help to Explain Exchange Rates?," 2016 Meeting Papers 1183, Society for Economic Dynamics.
    3. Hornstein, Abigail S. & Naknoi, Kanda, 2023. "FDI commitments increase when uncertainty is resolved: Evidence from Asia," Journal of Asian Economics, Elsevier, vol. 87(C).
    4. Anella Munro, 2016. "Bond premia, monetary policy and exchange rate dynamics," Reserve Bank of New Zealand Discussion Paper Series DP2016/11, Reserve Bank of New Zealand.
    5. Maurer, Thomas & Tran, Ngoc-Khanh, 2021. "Entangled risks in incomplete FX markets," Journal of Financial Economics, Elsevier, vol. 142(1), pages 146-165.
    6. Curatola, Giuliano & Dergunov, Ilya, 2023. "International capital markets with interdependent preferences: Theory and empirical evidence," Journal of Economic Behavior & Organization, Elsevier, vol. 212(C), pages 403-421.
    7. Mirela Sandulescu & Fabio Trojani & Andrea Vedolin, 2021. "Model‐Free International Stochastic Discount Factors," Journal of Finance, American Finance Association, vol. 76(2), pages 935-976, April.

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    More about this item

    Keywords

    Asset pricing; Market segmentation; Exchange rates; International risk sharing;
    All these keywords.

    JEL classification:

    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F10 - International Economics - - Trade - - - General

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