Why Are Exchange Rates So Smooth? A Household Finance Explanation

Abstract

Empirical moments of asset prices and exchange rates imply that pricing kernels are almost perfectly correlated across countries. Otherwise, observed real exchange rates would be too smooth for high Sharpe ratios. However, the cross-country correlation among macro fundamentals is weak. We reconcile these facts in a two-country stochastic growth model with heterogeneous households and a home bias in consumption. In our model, only a small fraction of households trade domestic and foreign equities. We show that this mechanism can quantitatively account for the smoothness of exchange rates in the presence of volatile pricing kernels and weakly correlated macro fundamentals.

CIP Deviations, the Dollar, and Frictions in International Capital Markets

“…Theoretical frameworks featuring segmentation by currency includeChien et al (2015),Dou and Verdelhan (2015), andGabaix and Maggiori (2015) Lustig and Verdelhan (2019). demonstrate the limits of models featuring incomplete markets without segmentation.13 These motives are quite distinct from the motives for unhedged foreign currency borrowing, such as those explored inBruno and Shin (2017),Bruno and Shin (2020), andSalomao and Varela (2018).…”