Exchange Rate Determination, Risk Sharing and the Asset Market View
Recent research in international asset pricing has argued that changes in real exchange rates can be understood using only asset market data and an equation that relates changes in the exchange rate to differences between representative agents’ intertemporal marginal rates of substitution (IMRSs). We show that asset market data and this equation, alone, are not sufficient to understand how real exchange rates are determined, nor are they sufficient to economically interpret time-series variation in real exchange rates. Instead, we argue that it is necessary to make specific assumptions about preferences, goods market frictions, and asset markets. We also clarify the connection between agents’ IMRSs and reduced-form stochastic discount factors (SDFs) that are identified using only asset market data. We show that reduced-form models of two SDFs that satisfy this equation have exactly the same economic content as an arbitrage-free statistical model of exchange rate dynamics.
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This paper was revised on March 25, 2014
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