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What do Financial Markets say about the Exchange Rate?

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  • Mikhail Chernov
  • Valentin Haddad
  • Oleg Itskhoki

Abstract

Financial markets play two roles with implications for the exchange rate: they accommodate risk sharing and act as a source of shocks. In prevailing theories, these roles are seen as mutually exclusive and individually face challenges in explaining exchange rate dynamics. However, we demonstrate that this is not necessarily the case. We develop an analytical framework that characterizes the link between exchange rates and finance across all conceivable market structures. Our findings indicate that full market segmentation is not necessary for financial shocks to explain exchange rates. Moreover, financial markets can accommodate a significant extent of international risk sharing without leading to the classic exchange rate puzzles. We identify plausible market structures where both roles coexist, addressing challenges faced when examined separately.

Suggested Citation

  • Mikhail Chernov & Valentin Haddad & Oleg Itskhoki, 2024. "What do Financial Markets say about the Exchange Rate?," NBER Working Papers 32436, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:32436
    Note: AP EFG IFM ME
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    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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