Working Paper: CEPR ID: DP13252
Authors: Mikhail Chernov; Drew Creal
Abstract: The currency depreciation rate is often computed as the ratio of foreign to domestic pricing kernels. Using bond prices alone to estimate these kernels leads to currency puzzles: the inability of models to match violations of uncovered interest parity and the volatility of exchange rates. This happens because of the FX bond disconnect, the inability of bonds to span exchange rates. Incorporating innovations to the pricing kernel that affect exchange rates but not bonds helps with resolving the puzzles. This approach also allows one to relate news about the cross-country differences between international yields to news about currency risk premiums.
Keywords: exchange rates; bond valuation; fx disconnect; spanning; affine models
JEL Codes: F31; G12; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| bond prices (G12) | pricing kernels (D49) |
| pricing kernels (D49) | depreciation rates (E43) |
| depreciation rates (E43) | exchange rate dynamics (F31) |
| bond prices (G12) | discrepancies in inferred depreciation rates (D25) |
| innovations in pricing kernel (G19) | observed exchange rate dynamics (F31) |
| pricing kernel component (D49) | depreciation rates (E43) |