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MOST RECENT RESEARCH on the theory of exchange rate determination treats the exchange rate as the relative price of two assets: domestic money and foreign money. The value of an asset depends on the distribution of its return. However, most of the research has dealt with models in which there is no uncertainty. The present paper focuses on questions that cannot be addressed in a world of certainty, because in such a world an asset is never risky. It investigates how purchasing power risks affect the determination of exchange rates. This investigation is pursued in a fairly general optimizing model. The present research is related to some recent work in international economics and in financial economics. It follows the approach of Obstfeld (1981) and Stockman (1980) in that it uses an optimizing model and takes into account the role of government transfers in the flow budget constraint of individuals. As in Calvo and Rodriguez (1977), Stockman (1980), and others, the fact that holdings of foreign monies are useful to domestic individuals is taken into account. Finally, the paper uses techniques developed in papers in the finance literature which build on Merton's (1973) asset-pricing model and use a concept of equilibrium developed in
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