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Why Are Exchange Rates So Smooth? A Household Finance Explanation

Author

Listed:
  • YiLi Chien

    (Federal Reserve Bank of St. Louis)

  • Hanno Lustig

    (Stanford Graduate School of Business)

  • Kanda Naknoi

    (University of Connecticut)

Abstract

Empirical moments of asset prices and exchange rates imply that pricing kernels have to be almost perfectly correlated across countries. If they are not, observed real exchange rates are too smooth to be consistent with high Sharpe ratios in asset markets. However, the cross-country correlation of macro fundamentals is far from perfect. We reconcile these empirical facts in a two-country stochastic growth model with heterogeneous trading technologies for households and a home bias in consumption. In our model, only a small fraction of households actively participate in international risk sharing by frequently trading domestic and foreign equities. These active traders, who induce high cross-country correlation to the pricing kernels, are the marginal investors in foreign exchange markets. In a calibrated version of our model, we show that this mechanism can quantitatively account for the excess smoothness of exchange rates in the presence of highly volatile pricing kernels and weakly correlated macro fundamentals.

Suggested Citation

  • YiLi Chien & Hanno Lustig & Kanda Naknoi, 2017. "Why Are Exchange Rates So Smooth? A Household Finance Explanation," Working papers 2017-20, University of Connecticut, Department of Economics.
  • Handle: RePEc:uct:uconnp:2017-20
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    References listed on IDEAS

    as
    1. Yili Chien & Harold Cole & Hanno Lustig, 2011. "A Multiplier Approach to Understanding the Macro Implications of Household Finance," Review of Economic Studies, Oxford University Press, vol. 78(1), pages 199-234.
    2. Pavlova, Anna & Rigobon, Roberto, 2010. "An asset-pricing view of external adjustment," Journal of International Economics, Elsevier, vol. 80(1), pages 144-156, January.
    3. Emmanuel Farhi & Xavier Gabaix, "undated". "Rare Disasters and Exchange Rates," Working Paper 71001, Harvard University OpenScholar.
    4. Chien, YiLi & Naknoi, Kanda, 2015. "The risk premium and long-run global imbalances," Journal of Monetary Economics, Elsevier, vol. 76(C), pages 299-315.
    5. Gavazzoni, Federico & Santacreu, Ana Maria, 2015. "International R&D Spillovers and Asset Prices," Working Papers 2015-41, Federal Reserve Bank of St. Louis.
    6. Warnock, Francis E., 2003. "Exchange rate dynamics and the welfare effects of monetary policy in a two-country model with home-product bias," Journal of International Money and Finance, Elsevier, vol. 22(3), pages 343-363, June.
    7. Markus K. Brunnermeier & Stefan Nagel, 2008. "Do Wealth Fluctuations Generate Time-Varying Risk Aversion? Micro-evidence on Individuals," American Economic Review, American Economic Association, vol. 98(3), pages 713-736, June.
    8. Riccardo Colacito & Mariano M. Croce, 2011. "Risks for the Long Run and the Real Exchange Rate," Journal of Political Economy, University of Chicago Press, vol. 119(1), pages 153-181.
    9. Doireann Fitzgerald, 2012. "Trade Costs, Asset Market Frictions, and Risk Sharing," American Economic Review, American Economic Association, vol. 102(6), pages 2700-2733, October.
    10. Patrick J. Kehoe & Fabrizio Perri, 2002. "International Business Cycles with Endogenous Incomplete Markets," Econometrica, Econometric Society, vol. 70(3), pages 907-928, May.
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    Cited by:

    1. 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.
    2. Hanno Lustig & Adrien Verdelhan, 2016. "Does Incomplete Spanning in International Financial Markets Help to Explain Exchange Rates?," NBER Working Papers 22023, National Bureau of Economic Research, Inc.
    3. 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.

    More about this item

    Keywords

    asset pricing; market segmentation; exchange rate; international risk sharing;

    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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