Working Paper: NBER ID: w9834
Authors: Anna Pavlova; Roberto Rigobon
Abstract: This paper develops a simple two-country, two-good model, in which the real exchange rate, stock and bond prices are jointly determined. The model predicts that stock market prices are correlated internationally even though their dividend processes are independent, providing a theoretical argument in favor of financial contagion. The foreign exchange market serves as a propagation channel from one stock market to the other. The model identifies interconnections between stock, bond and foreign exchange markets and characterizes their joint dynamics as a three-factor model. Contemporaneous responses of each market to changes in the factors are shown to have unambiguous signs. These implications enjoy strong empirical support. Estimation of various versions of the model reveals that most of the signs predicted by the model indeed obtain in the data, and the point estimates are in line with the implications of our theory. Furthermore, the uncovered interest rate parity relationship has a risk premium in our model, shown to be volatile. We also derive agents? portfolio holdings and identify economic environments under which they exhibit a home bias, and demonstrate that an international CAPM obtaining in our model has two additional factors.
Keywords: No keywords provided
JEL Codes: F31; F36; G12; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Exchange rate changes (F31) | International stock market prices (G15) |
| Positive output shock in one country (F41) | Exchange rate depreciation (F31) |
| Exchange rate depreciation (F31) | Stock market boost in foreign country (G15) |
| Demand fluctuations (E32) | Market responses (D49) |