Implications of Asset Market Data for Equilibrium Models of Exchange Rates

We characterize the cyclicality and predictability of exchange rates without committing to a specific model of preferences, endowment or menu of traded assets. When investors can trade home and foreign currency risk-free bonds without frictions, the exchange rate conditionally appreciates in states of the world that are worse for home investors than foreign investors. We show that its unconditional counterpart can only be overturned if the deviations from U.I.P. are large and exchange rates are highly predictable, conditions that do not hold in the data. Thus, without frictions in bond markets, it is impossible to match the empirical exchange rate cyclicality (the Backus- Smith puzzle) and the deviations from U.I.P. (the Fama puzzle) as well as the lack of predictability (the Meese-Rogoff puzzle). To relax this trade-off, we need small Euler equation wedges consistent with a home currency bias, home bond convenience yields, or financial repression, but we do not need market segmentation.