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How Can Asset Prices Value Exchange Rate Wedges?

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  • Karen K. Lewis
  • Edith Liu

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.

Suggested Citation

  • Karen K. Lewis & Edith Liu, 2022. "How Can Asset Prices Value Exchange Rate Wedges?," NBER Working Papers 30422, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:30422
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    More about this item

    JEL classification:

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

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