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Volatility, intermediaries, and exchange rates

Author

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  • Fang, Xiang
  • Liu, Yang

Abstract

We propose and estimate a quantitative model of exchange rates in which participants in the foreign exchange market are intermediaries subject to value-at-risk (VaR) constraints. Higher volatility translates into tighter VaR constraints, and intermediaries require higher returns to hold foreign assets. Therefore, the foreign currency is expected to appreciate. The model quantitatively resolves the Backus–Smith puzzle, the forward premium puzzle, and the exchange rate volatility puzzle and explains deviations from the covered interest rate parity. Moreover, the model implies both contemporaneous and predictive relations between proxies of leverage constraint tightness and exchange rates. These implications are supported in the data.

Suggested Citation

  • Fang, Xiang & Liu, Yang, 2021. "Volatility, intermediaries, and exchange rates," Journal of Financial Economics, Elsevier, vol. 141(1), pages 217-233.
    • Handle: RePEc:eee:jfinec:v:141:y:2021:i:1:p:217-233
    DOI: 10.1016/j.jfineco.2020.05.010
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    Cited by:

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    3. Maio, Paulo & Zeng, Ming, 2023. "On the driving forces of real exchange rates: Is the Japanese Yen different?," Journal of Empirical Finance, Elsevier, vol. 74(C).
    4. Jiang, Zhengyang, 2021. "US Fiscal cycle and the dollar," Journal of Monetary Economics, Elsevier, vol. 124(C), pages 91-106.
    5. Schneider, Andrés, 2022. "Who should buy stocks when volatility spikes?," Journal of Financial Markets, Elsevier, vol. 60(C).

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    More about this item

    Keywords

    Volatility; Financial intermediaries; Exchange rates; Currency returns; Value at Risk;
    All these keywords.

    JEL classification:

    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • F31 - International Economics - - International Finance - - - Foreign Exchange

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