Working Paper

Why Are Exchange Rates So Smooth? A Household Finance Explanation

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.

Keywords: Asset pricing; Market segmentation; Exchange rates; International risk sharing;

JEL Classification: F10; F31; G12; G15;

Status: Published in Journal of Monetary Economics

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Bibliographic Information

Provider: Federal Reserve Bank of St. Louis

Part of Series: Working Papers

Publication Date: 2015-11-27

Number: 2015-39

Note: Previous title: Why Are Exchange Rates So Smooth? A Segmented Asset Markets Explanation

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