Exchange Rate Determination, Risk Sharing and the Asset Market View
49 Pages Posted: 16 Mar 2012 Last revised: 30 Jan 2013
Date Written: December 15, 2012
Recent research in international finance has equated changes in real exchange rates with differences between the marginal utility growths of representative agents in different economies. The asset market view of exchange rates, encapsulated in this equation, has been used to gain insights into exchange rate determination, foreign exchange risk premia, and international risk sharing. We argue that, in fact, this equation is of limited usefulness. By itself, the asset market view does not identify the economic mechanism that determines the exchange rate. It only holds under complete markets, and even then, it does not generally allow us to identify the marginal utility growths of distinct agents. Moreover, if we allow for incomplete asset markets, measures of agents' marginal utility growths, and international risk sharing, cannot be based on asset market and exchange rate data alone. Instead, we argue that in order to explain how exchange rates are determined, it is necessary to make specific assumptions about preferences, goods market frictions, the assets agents can trade, and the nature of endowments or production.
Keywords: exchange rates, marginal utility, no arbitrage, stochastic discount factors
JEL Classification: F31, G15
Suggested Citation: Suggested Citation