Beyond Incomplete Spanning: Convenience Yields and Exchange Rate Disconnect
35 Pages Posted: 25 May 2021 Last revised: 6 Jul 2021
Date Written: May 24, 2021
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: Suggested Citation