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How Can Asset Prices Value Exchange Rate Wedges?

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Abstract

When available financial securities allow investors to optimally diversify risk across countries, standard theory implies that exchange rates should reflect this behavior. However, exchange rates observed in the data deviate from these predictions. In this paper, we develop a framework to value the welfare costs of these exchange rate wedges, as disciplined by asset returns. This framework applies to a general class of asset pricing and exchange rate models. We further decompose the value of these wedges into components, showing that the ability of goods markets to respond to financial markets through exchange rate adjustment has significant implications for welfare.

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  • Karen K. Lewis & Edith X. Liu, 2022. "How Can Asset Prices Value Exchange Rate Wedges?," Finance and Economics Discussion Series 2022-075, Board of Governors of the Federal Reserve System (U.S.).
    • Handle: RePEc:fip:fedgfe:2022-75
    DOI: 10.17016/FEDS.2022.075
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    More about this item

    Keywords

    Exchange rates and foreign exchange; Asset prices; Financial integration; Social costs;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • F30 - International Economics - - International Finance - - - General

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