Working Paper: CEPR ID: DP15337
Authors: Sofonias Alemu Korsaye; Fabio Trojani; Andrea Vedolin
Abstract: We provide a model-free framework to study the global factor structure of exchange rates. To this end, we propose a new methodology to estimate international stochastic discount factors (SDFs) that jointly price cross-sections of international assets, such as stocks, bonds, andcurrencies, in the presence of frictions. We theoretically establish a two-factor representation for the cross-section of international SDFs, consisting of one global and one local factor, which is independent of the currency denomination. We show that our two-factor specification prices a large cross-section of international asset returns, not just in- but also out-of-sample with R2s of up to 80%.
Keywords: international asset pricing; stochastic discount factor; factor models; financial frictions; market segmentation; incomplete markets; capital flows; regularization; lasso
JEL Codes: F31; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| global SDF (C69) | asset returns (G19) |
| global SDF (C69) | exchange rate appreciation (F31) |
| local currency basket factor (F31) | asset pricing (G19) |
| capital flows (F32) | local currency basket factor (F31) |
| financial intermediary constraints (G21) | global SDF (C69) |
| global volatility measures (F31) | global SDF (C69) |
| frictions (D74) | portfolio sparsity (G11) |
| frictions (D74) | market segmentation (M31) |
| global SDF (C69) | local currency basket factor (F31) |