The Global Factor Structure of Exchange Rates

Abstract

We propose a model-free methodology to estimate international stochastic discount factors (SDFs) that jointly price cross-sections of international stocks, bonds, and currencies in markets with frictions, and study the global factor structure of exchange rates. We theoretically establish a SDF decomposition into one global factor and a currency basket. We show that our global factor prices a large cross-section of international asset returns not just in- but also out-of-sample across different currency denominations. Moreover, the pricing ability of the global factor is largely independent of the market structure or the size and type of market friction.

Keywords: International asset pricing, stochastic discount factor, factor models, financial frictions, market segmentation, incomplete markets, capital flows

JEL Classification: F31, G15