Asset Prices and Exchange Rates

51 Pages Posted: 14 Jul 2003 Last revised: 16 Nov 2022

See all articles by Anna Pavlova

Anna Pavlova

London Business School; Centre for Economic Policy Research (CEPR)

Roberto Rigobon

Massachusetts Institute of Technology (MIT) - Sloan School of Management

Multiple version iconThere are 4 versions of this paper

Date Written: July 2003


This paper develops a simple two-country, two-good model, in which the real exchange rate, stock and bond prices are jointly determined. The model predicts that stock market prices are correlated internationally even though their dividend processes are independent, providing a theoretical argument in favor of financial contagion. The foreign exchange market serves as a propagation channel from one stock market to the other. The model identifies interconnections between stock, bond and foreign exchange markets and characterizes their joint dynamics as a three-factor model. Contemporaneous responses of each market to changes in the factors are shown to have unambiguous signs. These implications enjoy strong empirical support. Estimation of various versions of the model reveals that most of the signs predicted by the model indeed obtain in the data, and the point estimates are in line with the implications of our theory. Furthermore, the uncovered interest rate parity relationship has a risk premium in our model, shown to be volatile. We also derive agents? portfolio holdings and identify economic environments under which they exhibit a home bias, and demonstrate that an international CAPM obtaining in our model has two additional factors.

Suggested Citation

Pavlova, Anna and Rigobon, Roberto, Asset Prices and Exchange Rates (July 2003). NBER Working Paper No. w9834, Available at SSRN:

Anna Pavlova

London Business School ( email )

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Centre for Economic Policy Research (CEPR)

United Kingdom

Roberto Rigobon (Contact Author)

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

Cambridge, MA 02142
United States
617-258-8374 (Phone)
617-258-6855 (Fax)

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