Foreign Safe Asset Demand and the Dollar Exchange Rate

81 Pages Posted: 21 Mar 2018 Last revised: 2 Nov 2018

See all articles by Zhengyang Jiang

Zhengyang Jiang

Kellogg School of Management - Department of Finance

Arvind Krishnamurthy

Stanford Graduate School of Business

Hanno N. Lustig

Stanford Graduate School of Business; National Bureau of Economic Research (NBER)

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Date Written: March 15, 2018

Abstract

We develop a theory that links foreign investors' demand for the safety of U.S. Treasury bonds to the value of the dollar in spot markets. An increase in the convenience yield that foreign investors derive from holding U.S. Treasury’s induces an immediate appreciation of the US dollar and, going forward, lowers the expected return to a foreign investor from owning Treasury bonds. Under our theory, we show that the foreign convenience yield can be measured by the `Treasury basis,' defined as the wedge between the yield on foreign government bonds and the currency-hedged yield on U.S. Treasury bonds. We measure the convenience yield using data from a cross-country panel going back to 1988 and the US/UK cross going back to 1970. In both datasets, regression evidence strongly supports the theory. Our results help to resolve the exchange rate disconnect puzzle: The Treasury basis variation accounts for up to 41% of the quarterly variation in the dollar. Our results also provide support for recent theories which ascribe a special role to the U.S. as a provider of world safe assets.

Keywords: Covered Interest Rate Parity, Exchange Rates, Safe Asset Demand, Convenience Yields

JEL Classification: F31

Suggested Citation

Jiang, Zhengyang and Krishnamurthy, Arvind and Lustig, Hanno N., Foreign Safe Asset Demand and the Dollar Exchange Rate (March 15, 2018). Stanford University Graduate School of Business Research Paper No. 18-16. Available at SSRN: https://ssrn.com/abstract=3142280 or http://dx.doi.org/10.2139/ssrn.3142280

Zhengyang Jiang

Kellogg School of Management - Department of Finance ( email )

Evanston, IL 60208
United States

HOME PAGE: http://https://sites.google.com/site/jayzedwye/

Arvind Krishnamurthy

Stanford Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
United States

Hanno N. Lustig (Contact Author)

Stanford Graduate School of Business ( email )

Stanford GSB
655 Knight Way
Stanford, CA California 94305-6072
United States
3108716532 (Phone)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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