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The Global Factor Structure of Exchange Rates

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  • Vedolin, Andrea
  • Korsaye, Sofonias Alemu
  • Trojani, Fabio

Abstract

We provide a model-free framework to study the global factor structure of exchange rates. To this end, we propose a new methodology to estimate international stochastic discount factors (SDFs) that jointly price cross-sections of international assets, such as stocks, bonds, and currencies, in the presence of frictions. We theoretically establish a two-factor representation for the cross-section of international SDFs, consisting of one global and one local factor, which is independent of the currency denomination. We show that our two-factor specification prices a large cross-section of international asset returns, not just in- but also out-of-sample with R2s of up to 80%.

Suggested Citation

  • Vedolin, Andrea & Korsaye, Sofonias Alemu & Trojani, Fabio, 2020. "The Global Factor Structure of Exchange Rates," CEPR Discussion Papers 15337, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:15337
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    More about this item

    Keywords

    International asset pricing; Stochastic discount factor; Factor models; Financial frictions; Market segmentation; Incomplete markets; Capital flows; Regularization; Lasso;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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