The Global Factor Structure of Exchange Rates
54 Pages Posted: 3 Nov 2020
Date Written: October 1, 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 crosssection 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 crosssection of international asset returns, not just in- but also out-of-sample with R2s of up to 80%.
Keywords: Capital Flows, factor models, Financial Frictions, incomplete markets, International Asset Pricing, Lasso, Market Segmentation, regularization, Stochastic discount factor
JEL Classification: F31, G15
Suggested Citation: Suggested Citation