What do Financial Markets say about the Exchange Rate?

Abstract

We develop a general framework characterizing when exchange rates connect or disconnect from fundamentals across different financial market structures. International portfolio risk sharing governs how tightly exchange rates track households’ stochastic discount factors. We introduce a tractable sufficient statistic for connect: the prevalence of globally-traded risks, the component of asset risks that households in both countries can trade through available financial instruments. When globally-traded risks dominate, exchange rate puzzles persist regardless of market structure. In turn, disconnect requires neither extreme segmentation nor thin financial markets; it emerges whenever globally-traded risks are limited. Empirically, cross-country asset return correlations are weak, implying modest amount of globally-traded risks and pervasive disconnect in intermediated market structures. When correlations increase, as observed post-2008 or during high-risk episodes, exchange rates track fundamentals more closely. Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

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