Working Paper: NBER ID: w27892
Authors: Sofonias 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, and currencies, 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: exchange rates; stochastic discount factors; international finance; asset pricing
JEL Codes: F3; 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) | exchange rate dynamics (F31) |
| local currency basket factors (F31) | exchange rate dynamics (F31) |
| market segmentation increases (F61) | correlation among SDFs diminishes (C10) |
| global SDF (C69) | cross-sectional variation in asset returns (G12) |
| transaction costs (D23) | home bias in international portfolios (G15) |