Exchange Rates in a Stochastic Discount Factor Framework

Abstract

According to the uncovered interest rate parity (UIP) condition, expected changes in exchange rates should be equal to the interest rate differentials between foreign and domestic risk-free bonds. This chapter surveys empirical and theoretical risk-based approaches of exchange rates. It starts by laying down the basic theoretical framework, defining stochastic discount factors (SDFs) (also known as pricing kernels or intertemporal marginal rates of substitution) and exchange rates from a financial perspective. Then, the chapter reviews the recent body of empirical evidence emerging from this financial approach of exchange rates. Along this line, it describes a key methodological innovation, that is, the use of currency portfolios, and then turns to recent findings on exchange rates based on this new method. Finally, the chapter reviews the general equilibrium models that are consistent with stylized facts on currency markets. Controlled Vocabulary Terms currency portfolios; exchange rates; stochastic discount factor (SDF); uncovered interest rate parity

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