Beyond Incomplete Spanning: Convenience Yields and Exchange Rate Disconnect
55 Pages Posted: 25 May 2021 Last revised: 30 Aug 2022
Date Written: May 24, 2021
We introduce safe asset demand for dollar-denominated bonds into a tractable incomplete-market model of exchange rates. The convenience yield on dollar bonds enters as a stochastic wedge in the Euler equations for exchange rate determination. This wedge reduces the pass-through from marginal utility shocks to exchange rate movements, resolving the exchange rate volatility puzzle. The wedge also exposes the dollar's exchange rate to convenience yield shocks, giving rise to exchange rate disconnect from macro fundamentals and a quantitatively important driver of currency risk premium. This endogenous exposure identifies a novel safe-asset-demand channel by which the Fed's QE impacts the dollar.
Keywords: Exchange Rate Puzzles, Dollar, Convenience Yields, Incomplete Markets
JEL Classification: E44, F31, G15
Suggested Citation: Suggested Citation