Beyond Incomplete Spanning: Convenience Yields and Exchange Rate Disconnect

35 Pages Posted: 25 May 2021 Last revised: 6 Jul 2021

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)

Date Written: May 24, 2021

Abstract

We introduce convenience yields on dollar bonds into an incomplete-market equilibrium model of exchange rates and interest rates. The convenience yield enters as a stochastic wedge in the Euler equation for exchange rate determination. The model identifies a novel safe-asset convenience yield channel by which quantitative easing impacts the dollar exchange rate. Our model addresses three exchange rate puzzles. (1) The model can rationalize the low pass-through of SDF shocks to exchange rates and hence low exchange rate volatility. (2) It helps address but does not fully resolve the exchange rate disconnect puzzle. (3) The model generates an unconditional log currency expected return on the dollar that is in line with the data.

Keywords: Safe assets, exchange rates

JEL Classification: G15

Suggested Citation

Jiang, Zhengyang and Krishnamurthy, Arvind and Lustig, Hanno N., Beyond Incomplete Spanning: Convenience Yields and Exchange Rate Disconnect (May 24, 2021). Stanford University Graduate School of Business Research Paper, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3852298 or http://dx.doi.org/10.2139/ssrn.3852298

Zhengyang Jiang

Kellogg School of Management - Department of Finance ( email )

Evanston, IL 60208
United States

HOME PAGE: http://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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