Implications of Asset Market Data for Equilibrium Models of Exchange Rates
We characterize the relation between exchange rates and their macroeconomic fundamentals without committing to a specific model of preferences, endowment or menu of traded assets. When investors can trade home and foreign currency risk-free bonds, the exchange rate (conditionally) appreciates in states of the world that are worse for home investors than foreign investors. This prediction is at odds with the empirical evidence. We first show that it can be overturned (unconditionally) if the deviations from U.I.P. are large and exchange rates are highly predictable, which are conditions that do not hold in the data. More broadly, it is not possible to match the empirical exchange rate cyclicality (the Backus-Smith puzzle), the deviations from U.I.P. (the Fama puzzle) and the lack of predictability (the Meese-Rogoff puzzle). We then show that introducing Euler equation wedges, consistent with a home currency bias, home bond convenience yields, or financial repression, can resolve all of these puzzles.