Foreign Safe Asset Demand and the Dollar Exchange Rate

93 Pages Posted: 21 Mar 2018 Last revised: 23 Mar 2019

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 19, 2018

Abstract

We develop a theory that links the U.S. dollar's valuation in FX markets to foreign investors' demand for U.S. safe assets. When the convenience yield that foreign investors derive from holding U.S. safe assets increases, the U.S. dollar immediately appreciates, thus lowering the foreign investors' expected future return from owning U.S. safe assets. The foreign investors' convenience yield can be inferred from the wedge between the yield on safe U.S. Treasury bonds and currency-hedged foreign government bonds, which we call the U.S. Treasury basis. Consistent with the theory, we find that a widening of the U.S. Treasury basis coincides with an immediate appreciation and a subsequent depreciation of the U.S. dollar. Shocks to news about current and future convenience yields accounts for 54.2% of the quarterly innovations in the dollar. Our results lend empirical support to recent theories of exchange rate determination which impute a special role to the U.S. as the world's provider of safe assets and to the dollar, the world's reserve currency.

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 19, 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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