The Global Factor Structure of Exchange Rates
53 Pages Posted: 14 Oct 2020 Last revised: 21 Dec 2020
Date Written: September 23, 2020
We provide a model-free framework to study the global factor structure of exchange rates. To this end, we propose a new methodology to estimate international stochastic discount factors (SDFs) that jointly price cross-sections of international assets, such as stocks, bonds, and currencies, in the presence of frictions. We theoretically establish a two-factor representation for the cross-section of international SDFs, consisting of one global and one local factor, which is independent of the currency denomination. We show that our two-factor specification prices a large cross-section of international asset returns, not just in- but also out-of-sample with R2s of up to 80%.
Keywords: International asset pricing, stochastic discount factor, factor models, financial frictions, market segmentation, incomplete markets, capital flows, regularization, lasso
JEL Classification: F31, G15
Suggested Citation: Suggested Citation