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Why Are Exchange Rates So Smooth? A Household Finance Explanation

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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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  • YiLi Chien & Hanno Lustig & Kanda Naknoi, 2015. "Why Are Exchange Rates So Smooth? A Household Finance Explanation," Working Papers 2015-39, Federal Reserve Bank of St. Louis.
  • Handle: RePEc:fip:fedlwp:2015-039
    DOI: 10.20955/wp.2015.039
    Note: Previous title: Why Are Exchange Rates So Smooth? A Segmented Asset Markets Explanation
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    Cited by:

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    3. Shaojun Zhang, 2021. "Limited Risk Sharing and International Equity Returns," Journal of Finance, American Finance Association, vol. 76(2), pages 893-933, April.
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    5. 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.

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    More about this item

    Keywords

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

    JEL classification:

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

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