Exchange Rate Determination, Risk Sharing and the Asset Market View
Recent research in international finance suggests that changes in real exchange rates can be understood and interpreted using only asset returns and agents' intertemporal marginal rates of substitution. This asset market view of exchange rates has been used to gain insights into exchange rate determination, foreign exchange risk premia, and international risk sharing. We show that asset markets 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, frictions in the market for goods and services, the nature of endowments or production, and the assets that agents can trade.
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This paper was revised on May 8, 2013