Working Paper: NBER ID: w17564
Authors: Ian Martin
Abstract: I explore the behavior of asset prices and the exchange rate in a two-country world. When the large country has bad news, the relative price of the small country's output declines. As a result, the small country's bonds are risky, and uncovered interest parity fails, with positive excess returns available to investors who borrow at the large country's interest rate and lend at the small country's interest rate. I use a diagrammatic approach to derive these and other results in a calibration-free way.
Keywords: forward premium puzzle; uncovered interest parity; two-country model; asset prices; exchange rates
JEL Codes: G12; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Large Country Negative Economic News (F69) | Small Country Relative Price Decline (P22) |
| Small Country Relative Price Decline (P22) | Small Country Bonds Considered Risky (F34) |
| Large Country Negative Economic News (F69) | Small Country Bonds Underperform (G15) |
| Small Country Bonds Underperform (G15) | Higher Required Return for Investors (G19) |
| Large Country Output Growth (O57) | Small Country Bond Valuation (G15) |
| Small Country Currency Depreciation (F31) | Increase in Risk Premium on Bonds (E43) |